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Ask An Advisor: What Midyear Moves Will Cut Our Tax Bill?


We gained additional income and didn’t withhold enough on our Form W-4. We are currently not putting money into a retirement account but have access to a 401(k) through our employer. Would we be able to correct our withholding deficit by putting money into a 401(k)? How do we go about figuring out how much to put in it? Would we still have to adjust our Form W-4? And if so, by how much?

– Dana

I get this type of question a lot as a certified public accountant (CPA), but often after it’s too late to do anything about it. I’m glad you asked this now instead of in December or next year.

Doing some midyear tax planning can be helpful when you’ve had a change in circumstances. Figuring things out when you still have plenty of time to take action will help you avoid tax-time anxiety and an unmanageable tax bill in April.

In your case, a two-pronged approach makes the most sense. You can take steps to both reduce your total tax bill and any unpaid balance due.

financial advisor may help you understand the tax impacts of your investment and income decisions.

Dealing With Untaxed Income

Man filing taxesUntaxed income – not to be confused with nontaxable income – lands a lot of people in hot water. This is income received with no taxes taken out and includes sources such as:

  • Investment income
  • Interest
  • Pensions
  • Side gigs
  • Rental income

People are often unaware of how these types of income will increase their tax bills, so they end up owing much more than expected when they file their tax returns. A combination of two strategies can help in this situation.

First, you can reduce your taxable income, meaning the amount of income on which you have to pay taxes. You can do this in a few different ways such as:

  • Increasing traditional retirement plan contributions.
  • Taking advantage of health savings accounts (HSAs) and flexible spending accounts (FSAs).
  • Bunching potential deductions such as medical bills and donations so you can maximize itemized deductions.

If it looks like you’ll still owe money after you’ve reduced your taxable income, your next step will be reducing the tax balance due. It can be tricky to get this exactly right, but it doesn’t have to be perfect. As long as you’ve met the IRS safe harbor requirements, you’ll be able to avoid underpayment penalties.

Generally, if you’ve paid 90% of your current year’s tax bill or 100% of the total tax from your previous year’s return, the IRS won’t charge underpayment penalties even if there’s a balance due when you file.

To make sure you’ve paid in enough, you can make estimated tax payments, increase the withholding taxes from your paycheck or have taxes withheld from your untaxed income.

If you have the option to increase your withholding taxes, that’s the better choice for two key reasons. First, it’s easier to manage a little extra out of every paycheck than coming up with a quarterly lump sum and remembering to pay it on time.

Second, if you don’t make four equal estimated tax payments, the IRS may tack on an additional “underpayment of estimated tax” penalty. Withholding taxes are treated as if they were paid evenly throughout the year, even if they weren’t.

Use Your 401(k) to Reduce Taxable Income

Since you have access to a 401(k) through your job, you can lower your taxable income by making pretax contributions. This strategy will reduce your tax bill, but not dollar for dollar. For example, if your tax rate is 10% and you earn $50,000, your tax would be $5,000. If you contributed $5,000 to your 401(k), your taxable income would drop down to $45,000 with tax of $4,500 – a $500 tax savings. And the financial benefits don’t end there.

You’ll also be increasing your postretirement resources by your contributions and all the tax-deferred earnings they generate. Plus, if your employer makes matching contributions – and many employers do – you’ll be adding free money to your retirement account.

 Manage Withholding Taxes to Reduce Balance Due

Man filing taxesIncreasing your withholding tax is the easiest way to make up for any potential shortfalls due to untaxed income. Your first step here: Choose the source for your extra withholding. You can do that through your paycheck or request to have taxes withheld from your pension payments or other untaxed sources.

The next step involves figuring out how much extra to withhold. This process equates to doing a midyear tax check-up to make sure you’re on track with your tax payments. As you’re going through this process, aim for $0 – meaning no refund and no balance due. You will still end up either getting a small refund or owing a little bit, but the closer to zero the better. After all, you don’t want to give the IRS a huge interest-free loan or end up owing more money than you can comfortably pay at once.

So how can you figure out your tax bill? The IRS offers a free withholding estimator on its website, but it’s not the easiest tool to use.

For an easier and often more accurate check-up, look to last year’s tax preparer. Many personal tax prep software programs offer a next-year estimator as part of the package. If you did your own taxes, check to see if the software you used has this function. If you worked with a CPA or other tax preparer, ask them to help you come up with the new number.

Once you know how much extra to withhold, you’ll need to take one more step to make it happen. To have more taxes taken out of your paycheck, you’ll fill out a new Form W-4 for your employer. If you have online access to your payroll, you can probably make the change right there. Otherwise, contact your payroll or human resources department and ask them for the form. To have taxes withheld from your pension, contact the provider and let them know you want to do this. They’ll give you a Form W-4P to complete.

If your situation changes, you can always readjust your withholding. Remember, both income and deductions figure into your final tax bill, so you’ll want to make sure to account for changes in either. And if your tax picture gets more complicated, check with a tax professional to help you figure out the best strategies to manage your annual tax burden.

Michele Cagan, CPA, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email and your question may be answered in a future column.

Please note that Michele is not a participant in the SmartAdvisor Match platform.

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