Common Cents #24 - Withholding

 

Common Cents – Income Tax Withholding Strategies

 

The U.S. Tax system is a “Pay-as-you- go” system. In other words, Uncle Sam wants us to pay tax today on the money we made today. This is accomplished by having employers withhold part of our salary and send it in as income tax.

Of course, the tax system is complicated with credits and deductions for all kinds of things. There are varying tax rates depending upon married status, and many of us have multiple sources of income. The solution is to file a tax return sometime after the first of the year and before April 15 that reconciles what we have paid with withholding with what we should have paid based on all of those variables. We may owe more if we haven’ t paid in enough, or we may have a refund coming if we overpaid. Ideally, we should come out about even, neither owing more nor getting a refund.

For some reason, tax season has become “refund season” with about 80% of Americans getting a refund because they had too much money taken out of their paycheck. The IRS would like to reduce this problem and get that money back in people’s hands each month instead of waiting until the next spring. For that reason, the W-4 form was redesigned for 2020. The W-4 is the form you fill out that tells your employer how much money to take out for your taxes. It stays with your employer; it is not sent to the government.

Incidentally, if you started your current job before January 2020, you do not have to fill out new W-4, though some employers are asking their employees to do that.

The new form asks a lot more questions, some of which you may not want to share with your employer, like your extra job, rental income, or the trust fund or lottery check you get each month. Fortunately, everything except your name, address, and Social Security number is optional. You can leave everything else blank if you choose to do so.

If you answer all the questions or go to the “Estimator” app on the IRS.gov web site, you will likely find that your paycheck has grown because there will be considerably less withholding. But you will be quite surprised next April when you not only do not get a refund but have a big tax bill instead.

In a few case studies we have done, a typical taxpayer went from getting a $1,000 refund using the old W-4 to owing over $3,000 with the new W-4. That is because each monthly paycheck received by the employee was over $300 more using the information on the new W-4 to calculate their withholding.

Ideally, assuming your situation hasn’t changed from last year, look at your total tax bill from last year, divide by the number or times you got paid and have your employer deduct that much from each check. You can do that by going straight to Step 4c on the W-4.  It will prevent the surprising amount that would become due next April 15 if this strategy is utilized.