With every paycheck, your employer withholds some of your earnings for taxes. If too much is withheld, it’s true that you will receive a refund, but when you really think about it, by waiting until tax season to claim that money back, you’ve essentially provided the IRS with an interest-free loan during the year. On the other hand, if you owe taxes when you file your return, you may have to scramble to pay what’s due, and you could also owe interest and penalties to the IRS if you don’t have enough withheld throughout the year.
The IRS has a “pay as you earn” policy, meaning that as you earn money throughout the year, the IRS expects that you’ll send them what you believe to be your best estimate of what the taxes are on that income. Your employer helps with this calculation and sends it on your behalf, but they use information you provide them to best estimate for you.
The ideal way to handle your tax withholding is to have just enough taxes withheld to prevent you from incurring penalties when your tax return is due, but still owe just a little bit rather than receive a refund. Yes, you’ll have to make sure you have a little set aside to make that payment in April each year, but in the meantime, you get to enjoy all of the money you earn throughout the year rather than waiting for the IRS to return it to you upon filing your return.
When you have a W-2 based job, the best way to find that perfect balance of withholdings is to properly complete Form W-4 (and its accompanying worksheets) when you begin a job, and providing an updated Form W-4 to your employer when your circumstances change.
Using Form W-4 to choose the proper withholding amount
Two factors determine how much income tax your employer withholds from your regular pay: how much you earn and the information you provide on Form W-4. This form asks you for three pieces of information:
- Do you have a working spouse or other income besides this job? (Answering yes will require additional worksheets to make sure you’re having enough withheld)
- How many qualifying children under age 17 and other dependents do you have?
- Do you have other income such as from dividends, interest, alimony or other non-job sources? This is optional, but answering correctly here will help your employer withhold enough to cover any additional taxation due to that income, should it push you into a higher tax bracket.
- Do you itemize your deductions and if so, what is the estimated total of those deductions? You would only complete this IF you itemize, otherwise the form assumes you take the standard deduction (90% of taxpayers currently use the standard deduction)
- Is there an additional amount you want withheld from your paycheck? This is optional. You might choose it if, for instance, you earn freelance or other income and would like to increase your withholding to cover that income (although you should also consider paying quarterly estimated taxes in this case).
When you need to update your W-4
To avoid surprises at tax time, it's a good idea to periodically check your withholding. Otherwise, there are some key life changes that definitely warrant an update. Those include:
- When you're married and either of you starts or stops working
- When you or your spouse are working more than one job
- When you have significant nonwage income, such as interest, dividends, unemployment compensation, or self-employment income, or the amount of your nonwage income changes
- When you'll owe other taxes on your return, such as self-employment tax or household employment tax
- When you have a life change (such as a marriage, divorce, birth or adoption of a child, new home, retirement) that affects the tax deductions or credits you may claim
- When any qualified dependent turns age 17, as the deduction for dependents decreases
- When there are tax law changes that affect the individual tax rules
If you find that you need to make changes to your withholding, you can do so at any time simply by submitting a new Form W-4 to your employer. To check on your withholding amount and to see whether you need to make changes to your W-4, the IRS has a comprehensive Withholding Calculator on their website. You'll need your most recent paystub as well as last year's tax return. You won't need to enter any personally identifiable information that ties the numbers you enter to you, but the more accurate the numbers you use, the more effective the calculator will be. Check it out here.
If the form looks different than you remember, it probably is
Due to the tax changes that were implemented in 2017, the IRS issued an updated Form W-4 that helps you account for the changes in an easier way. For example, your tax withholding is no longer calculated based on the number of allowances, but instead on the factors listed above. If it’s been a while since you’ve updated your form and you haven’t switched jobs, it’s not a bad idea to take a look and see if you need to submit a new form to your payroll department. It can help ensure you’re having the ideal amount withheld, so you can avoid big tax surprises in the future. This article, 'What You Need to Know About the New W-4 Form' has more information on the new form.