Monday, November 22, 2010

Federal Income Taxes: don't underpay!

Due to an error on our part, we weren't withholding enough federal taxes this year. What happened is this: Last year when Tammy went on maternity leave for six months, we changed our withholdings on her W-4 to reflect the fact that she'd only be working part of the year. When 2010 began, we didn't change it back, and thus we only withdrew enough taxes per pay period as though she were making half as much as she does.

This is not good. This used to be not too terrible. If we'd underpaid prior to 2008, then on April 15th, we could write a check to the US Treasury for the difference, and all would be well. This changed in tax year 2008. Now if we underpay by more than %10, the IRS can extract a penalty. (There are exceptions to this penalty, but it's reading legalese, and requires a small business, if interested, see this link).

I know the IRS has their W-4 withholdings estimate (for W-2 wage earners), but it's never quite that simple. I'd like something more accurate, so I do the following:

Total Income - Deductions = Adjusted Income

Simple, right?

Total Income is how much you're going to make in 2010. For example, let's say it's $100,000 (not our actual income). This includes interest and dividend income that I might make from investments.

Deductions are 401(k) and IRA contributions, as well as mortgage interest and donations made to charities, healthcare, and property taxes. If you're not itemizing your deductions, use the standard deduction.

I owe federal taxes on the Adjusted Income.

In our example, let's say we have $20,000 in deductions and we're itemizing. That means that our Adjusted income is $80,000 (not our actual AGI).

To figure out federal taxes owed on your adjusted income, I determine your filing status (married filed jointly, married filed separately, or single), then look up my tax per bracket.

I'm married filing jointly. Then according to the tax table, we owe:
10% bracket - $1675.00 (Taxes on income between 0 and $16,750.00)
15% bracket - $7687.50 (Taxes on income between $16750.00 and $68,000.00)
25% bracket - $3000.00(Taxes on income between $68,000.00 and $80,000)

Subtotal: $12362.50

We have a child, so the tax credit for one child is $1000.00. Thus, the total tax becomes: $11,362.50

Make sure that you're within %10 of that number on December 31, 2010, and you (probably) won't get penalized. Of course, it would have been better if we'd gotten it right the first time. This flow chart scares me and I'm hoping TurboTax 2010 will help me through it.

If you buy, sell, and trade stocks, this math gets harder, as proceeds from stock sales are taxed differently than regular income, and I'm not going to cover that here because it makes my head hurt to estimate that stuff.

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