Definition
Underwithholding refers to the situation when an individual has not had enough tax withheld — or has not made sufficient payment of estimated taxes throughout the year. As a result, they could owe tax when they file their tax return. Underwithholding could potentially lead to penalties, accrue interest, and a larger tax bill.
Phonetic
The phonetic spelling of “Underwithholding” is: /ˌʌndərwɪðˈhoʊldɪŋ/
Key Takeaways
<ol><li>Underwithholding occurs when insufficient taxes are withheld from an employee’s earnings, leading to a higher tax bill when filing income tax returns.</li><li>It may result in penalties from the IRS for not meeting the expected contributions throughout the year. This is to ensure that taxes are paid evenly throughout the year.</li><li>Guarding against underwithholding can be overseen by routinely checking withholdings using the IRS tax withholding estimator, ensuring that sufficient funds are being withheld from each paycheck to suffice the year’s tax obligations.</li></ol>
Importance
Underwithholding is an important finance term because it relates to the management of personal income tax. When taxpayers fail to withhold sufficient funds from their wage or income for taxes, it’s known as underwithholding. This could lead to unexpected tax bills and potential penalties at the end of the year because the IRS requires taxpayers to pay most of their tax liability during the year as income is earned. Therefore, understanding and avoiding underwithholding is crucial in financial planning and avoiding potential monetary penalties or surprise tax bills.
Explanation
Underwithholding is a financial term typically used in reference to tax dealings. The purpose of underwithholding arise when a taxpayer chooses or inadvertently pays less in payroll deductions throughout the year than the actual tax liability, which in effect means they have underwithheld tax from their paycheck. This is often a conscious choice done to have access to more money during the year. However, underwithholding has certain implications. The most evident is that it can lead to a large tax bill when it comes time to file your tax return. If a significant amount of tax has not been paid throughout the year, the taxpayer is responsible for paying it at once during the tax season. In extreme scenarios, underwithholding might result the IRS imposing penalty for underpayment of tax. Conversely, it can be beneficial if a taxpayer needs higher cash flow during the year and is ready to face a potentially larger tax bill during filing season. In essence, this involves using the IRS as a “no-interest lender” for the year.
Examples
Underwithholding is a tax term that refers to insufficient tax being withheld from an individual’s income, leading to a potential tax liability when filing a return. Here are three real-world examples:1. Independent Contractors: Often, independent contractors such as freelancers, consultants, or self-employed individuals may experience underwithholding. They may not have enough tax withheld from their earnings during the year because they’re responsible for paying their own taxes, including Social Security and Medicare taxes that would normally be paid partly by their employer.2. Multiple Jobs or Salary Increase: An individual might start the year with a low-paying job, with taxes withheld at an appropriate rate. However, if they switch jobs to one that pays significantly more or they hold multiple jobs, the previous withholding might not be enough to cover their new tax liability, leading to underwithholding.3. Unearned Income: People who earn a large portion of their income from unearned income like investments, dividends, or capital gains might also face underwithholding of taxes. These sources of income might not have any taxes withheld at the source, potentially leading to tax liability at the end of the year.
Frequently Asked Questions(FAQ)
What is underwithholding in terms of finance?
Underwithholding is a situation where an individual has not had enough taxes withheld from their income throughout the year. This can lead to a large tax bill when filing their annual tax return.
What can cause underwithholding?
Factors such as having multiple jobs, earning income that is not subject to withholding like dividends or interest, or having a major life change such as marriage or the birth of a child can all contribute to underwithholding.
What are the potential consequences of underwithholding?
If you don’t withhold enough tax from your salary, you may end up owing a significant sum to the IRS at the end of the year. Moreover, you may also have to pay penalty and interests for underpaying your due taxes.
How can I avoid underwithholding?
You can avoid underwithholding by making sure you accurately complete your W-4 form, making necessary adjustments for any additional income or changes in your circumstances throughout the year. If necessary, you can also make estimated tax payments to the IRS.
Can I fix underwithholding once it already happened?
Yes, if you realize you’re underwithholding mid-year, you can submit a new W-4 form to your employer with corrected information to withhold more taxes from your earnings for the rest of the year.
How can I check if I am underwithholding my taxes?
You can use an IRS Withholding Estimator tool online, which can help calculate the correct amount you should be having withheld from your paycheck.
Is underwithholding ever a good strategy?
Generally, it’s best to avoid underwithholding to prevent being liable for a large tax bill and possible penalties. However, some may choose to do so if they prefer to have control over their money throughout the year and are confident in their ability to save accordingly for their tax liability.
Related Finance Terms
- IRS (Internal Revenue Service)
- W-4 Form
- Tax Liability
- Withholding Tax
- Pay-as-you-earn tax
Sources for More Information
