Finding out at tax time that a client hasn’t withheld enough is never a good situation. Now you have to explain why they owe more than expected and, in some cases, why there is an underpayment penalty too.
The problem often starts months earlier. A client changes jobs, picks up extra income, or never updates a W-4 after something changes. The preparers who catch these gaps early have far more options than those who find them at filing time.
So how do you catch these problems sooner without adding another pile of work to your plate? Here are the steps you can put in place throughout the year, along with where software for tax professionals can help.
Start With the Clients Most Likely to Have a Withholding Problem
You don’t need to run a midyear withholding check for every client. Begin with the people whose last return or current situation gives you a reason to take another look.
Someone who owed unexpectedly last year is an obvious place to start. The same goes for clients with multiple W-2 jobs, a working spouse, new freelance or gig income, retirement distributions, or a major life change such as marriage or divorce. Multiple jobs deserve particular attention because Form W-4 has a separate Step 2 for households with more than one job at a time.
Don’t send these clients a generic “Has anything changed?” email. Ask what you actually need to know. Did you change jobs? Did your spouse start or stop working? Have you picked up freelance work? Are you taking retirement distributions? Did you have a large investment gain?
If something has changed, ask for the client’s latest pay stubs and details of any other income they’re expecting for the year. You want the year-to-date income and federal tax already withheld, along with enough information to estimate what the rest of the year may look like.
Once you have those numbers, check whether their current withholding and estimated payments are likely to cover what they’ll owe. If they’re falling short, you can figure out whether they need to update a W-4, make estimated payments, or both.
Compare Withholding With What the Client Is Likely to Owe
Now you need to see whether the client is paying enough tax as the year goes on. Look at the latest pay stub, year-to-date federal withholding, expected income for the rest of the year, and any estimated payments already made. For a joint return, bring in the spouse’s numbers as well. Don’t forget income with little or no withholding, such as freelance work, investments, bonuses, or taxable retirement distributions.
Estimate what the client is likely to owe for the year and compare that with the tax they’ve already paid and expect to pay. Check the safe harbor at the same time. In general, that’s 90% of the current year’s tax or 100% of the prior year’s tax, increasing to 110% of the prior year’s tax for certain higher-income taxpayers.
One projection won’t fit every client. Someone who earns a large chunk of their income late in the year may be better served by the annualized income installment method. It bases the required installments on when the income was earned instead of assuming the client earned it evenly throughout the year.
Look for the Places Tax Commonly Gets Missed
If the projection shows a shortfall, find out where it’s coming from. Start with income that may have come in without enough tax being paid along with it.
- Multiple jobs: Each employer withholds based on the W-4 it has on file. A client with two jobs or a working spouse can still come up short if the other job isn’t accounted for correctly.
- Freelance and 1099 income: There may be no withholding at all. Estimated payments can also fall behind if the client earns more than expected.
- Bonuses, investment gains, and other one-time income: The client may owe more tax for the year even though the amount being paid toward it hasn’t changed.
- Retirement income: Pension and IRA distributions can leave a client short if too little federal tax is withheld from the payments.
Once you know where the shortfall came from, you know what to fix. You may need to update a W-4, change the withholding on a retirement distribution, increase estimated payments, or use more than one of these.
Use Accounting Tax Software to Fix the Shortfall
Review the return information to identify any missing or incorrect entries before e-filing. Your accounting tax software should be able to support this step. Software with Interview Mode and diagnostic tools can be especially helpful.
The fix depends on where the income comes from. For clients who need to increase wage withholding, use your software’s W-4 form to prepare the updated information with your client. If the client has freelance, investment, or other income that isn’t adequately covered by withholding, use a 1040-ES worksheet and vouchers to work out estimated payments for the year.
Tax software that runs diagnostics before a return is e-filed gives you another chance to deal with missing information or errors. It doesn’t replace your review of the client’s withholding, but it can help catch return-entry problems before the return is sent.
Keep Up With Estimated Tax Payments
Estimated payments shouldn’t be calculated once and forgotten. Changes in freelance income, investment income, or other untaxed income during the year require re-running the numbers and adjusting the remaining payments.
Keep a record of what the client was supposed to pay and what they actually paid. Federal estimated taxes are generally due in April, June, September, and January. Sometimes, a client may say they made a payment, but you can’t confirm it. If that’s the case, check their IRS online account or account transcript before entering it on the return.
Use each upcoming payment as a reason to check in. Remind the client what’s due, but also ask whether their income has changed since you last ran the numbers. If it has, recalculate the remaining payments instead of carrying an old estimate through the rest of the year.
Make Withholding a Year-Round Conversation
You don’t have to wait until you’re preparing a return to find out a client hasn’t paid enough tax. Check in when their income changes, revisit estimated payments during the year, and keep a record of the adjustments you’ve recommended.
Some of that work gets easier when the return itself is organized. The right tax preparer software takes you through the return step by step. Smart diagnostics will check for missing or incorrectly entered fields before e-filing. And should you run into a software question, your software platform should provide year-round support.
