What is Underwithholding
Let me explain underwithholding directly to you—it's that tax scenario where you haven't had enough taxes pulled from your wages over the year to match what you actually owe the tax authorities.
Breaking Down Underwithholding
Underwithholding specifically means you've withheld too little from your wages or other income sources during the year to cover your tax bill. Withholding is simply the chunk of your paycheck that gets deducted upfront for federal, state, and local taxes. The IRS figures out your federal withholding based on your income level, whether you're married or single, how many dependents you claim, and your filing status—couples, you have to pick joint or separate filing. You can choose to withhold extra, say for a side gig where taxes aren't automatically deducted, or reduce it if you expect big deductions. You set all this up with your employer using Form W-4, the Employee's Withholding Certificate.
By paying taxes straight from each paycheck, you cut down on what you owe when you file your annual return. If you haven't covered enough, you'll owe the rest when you file, and if it's a big shortfall, expect a penalty. To dodge that penalty, make sure you've paid at least 90% of this year's taxes or 100% of last year's—whichever is smaller. You might still avoid it if the unpaid amount is under $1,000 or if you had zero tax liability last year.
Why Would You Choose to Underwithhold?
Some people intentionally underwithhold their taxes. For instance, you might take the money that would have been withheld and invest it instead—if you make a profit, you end up ahead after settling your taxes. But remember, if you underwithhold too much, you'll face penalties. And if you claim more allowances on your W-4 than you're entitled to just to reduce withholding, you could get hit with charges for providing false information.
Underwithholding’s Opposite: Overwithholding and Its Benefits
On the flip side, you could opt for overwithholding by having more taken out than you'll likely owe. This way, when you file your return, you get a refund. However, overpaying like this basically hands the IRS an interest-free loan with your money.
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