After nearly a year of living through “unprecedented times,” you are likely trying to avoid any unwelcome surprises. Planning ahead can prevent you from being caught unaware and, more importantly, keep you on track. That’s why we’d like to share five common events that can lead to tax surprises, as well as what to do if any of these situations happen to you.
An unexpected 1099 arrives. If you’ve spent most of your life as a W-2 employee and only recently branched out into freelance work, you may be surprised to receive a 1099 in the mail. These report money that clients paid you for freelance, side work, or independent contractor work of $600 or higher, and more often than not, tax was not withheld. Now is a good time to gather receipts and other records of business expenses that can reduce your net income and therefore your taxes; you can also contribute to an IRA before April 15 to reduce your taxable income.
You reduced your paycheck withholdings. Many people who normally opt to withhold more in taxes changed their elections last year to receive more take-home pay throughout the year. For those accustomed to receiving a large refund, owning taxes can be quite a shock. If this applies to you, it’s better to find out how much you owe earlier so that you have more time to prepare to pay. And if your cash flow situation has improved, be sure to readjust your W-4 so you don’t face the same situation when you file your taxes next year.
You received unemployment compensation. Unemployment income is subject to income tax, including the additional amounts provided by the federal government in 2020. In the next few weeks, if this applies to you, you will receive a 1099 in the mail showing the amount you received. It will also indicate whether you opted to have taxes withheld already, and you can prepare accordingly. If you’re still receiving unemployment pay, you may want to opt to withhold taxes so prevent a surprise again next year.
You took an emergency distribution from a retirement account. The CARES Act allowed for pandemic-related withdrawals of up to $100,000 from retirement accounts without the typical penalty for early withdrawal. However, that withdrawal amount is still subject to income tax, which some individuals may not have realized when they took the distribution. If this applies to you, it’s better to find out how much you owe earlier so that you have more time to prepare on how to pay the tax bill.
You completed a Roth conversion. When you move money from a pre-tax retirement account (such as an IRA) to a Roth, you’re taxed on the money when it’s moved, not when it’s withdrawn in the future. While this may have made sense for your financial situation and may be a sound long-term strategy, you may have forgotten about the short-term tax implications, particularly if you completed a Roth conversion in the early part of last year. This is another example of a case where filing sooner rather than later can give you more time to prepare on how to pay your tax bill.