WHAT IS Underwithholding

Underwithholding is a term that refers to a specific tax situation in which an individual did not withhold an adequate amount of taxes from their wages during the year to cover the amount of taxes they owe.

BREAKING DOWN Underwithholding

Underwithholding is a term used to refer to an instance when an individual withheld an inadequate amount of taxes from wages or other income during the year to cover the amount owed to tax authorities. Withholding itself refers to the portion of an individual’s wages that their paycheck does not include; instead, the federal, state and local tax authorities collect it. The IRS calculates the amount withheld from the individual’s paycheck from the income amount, marital status, number of dependents, and number of jobs held.

Paying taxes on one’s income directly from each paycheck reduces the amount of taxes owed when an individual submits an annual tax return. If an individual owes money when they submit their income tax return, they have underwithheld. If an individual finds that they are in an underwithholding situation, they will have to pay a balance when they file their income taxes. Significant underwithholding can result in an unpleasant surprise for the taxpayer, especially if there is substantial interest or penalties involved. Generally, individuals consider it a good idea to overwithhold in order to avoid a financial surprise at filing time that could become a significant financial burden.

Why Would an Individual Choose to Underwithhold?

Some taxpayers deliberately choose to have their taxes underwithheld for a variety of reasons. For example, a sophisticated taxpayer may take the amount that would have been withheld and invest that same amount. If an individual invests the money that would have been withheld and turns a profit, they have increased their yearly profitability, and actually come out ahead after paying their individual income taxes.  Another individual simply may not wish to have the government hold on to their money during the year and keep it in a separate account to earn interest instead. Also, if an individual overpays their taxes they in essence give the Internal Revenue Service an interest-free loan.

Underwithholding’s Opposite: Overwithholding and its Benefits

A taxpayer might also choose to do the opposite of underwithholding and instead overwithhold. An individual can accomplish this by withholding more than they will most likely owe in income tax. If an individual overwithholds, they will then receive a tax refund after they have filed their return.