How to figure tax withholdings
Are Your Tax Withholdings Correct?
If you are employed, your taxes are most likely collected on a pay-as-you-go basis, meaning a little bit is withheld from each paycheck. It is assumed that it is easier and less painful to pay small amounts throughout the year than to pay one huge bill once a year. However, the amount of taxes that is withheld from our paychecks is often different from our actual tax liability, which is why some people get refunds, because their withholdings are more than their liability, and some people owe, because their withholdings are less than their liability.
Avoid large refunds and bills
No one wants a big bill from the IRS – even if you have the money, it is not fun to part with a large chunk of change – but fewer people feel that way about getting a refund. In fact, many people look forward to it. However, getting a big refund is usually not beneficial. Not only are you unnecessarily lowering your take-home pay, since you are having more taxes withheld than you need to, but you are also essentially loaning the government money interest-free for the year. This is money that you could have put in an interest-bearing account or used to pay bills. If you have balances on your credit cards or other types of debt, being able to pay extra could save you hundreds or thousands of dollars in interest payments.
Increasing your take-home pay and having more money to pay bills may sound nice, but you want to avoid having so little in taxes withheld from your paycheck that you wind up having to pay a heap of cash come April 15. It is best to break even – neither owe nor get a refund. Of course, it can hard to have your withholdings exactly match your liability, but if the amount you receive or owe is consistently large, it may be time to make a change.
Form W-4 is what you use to tell your employer how much to withhold from your paycheck for federal taxes. You are required to fill out this form when you start a new job, but you can submit a new one whenever you want. Circumstances that can affect your tax liability and may warrant a change in your withholdings include:
- Birth of a child
- Home purchase
- Change in employment status for you or your spouse
Form W-4 is available on the IRS’s website at www.irs.gov. It contains three sections that allow you to determine your withholdings: the Personal Allowances Worksheet, Deductions and Adjustments Worksheet, and Two-Earners/Multiple Jobs Worksheet. The more allowances you claim on the form, the less is withheld from your paycheck for taxes.
Personal Allowances Worksheet
This worksheet helps you determine your withholdings based on your family status. Everyone must fill out the Personal Allowances Worksheet, unless they are exempt from withholding. You may be exempt if you had no tax liability last year and expect no liability this year. With this worksheet, you can claim an allowance if no one can claim you as a dependent, you are single or married (although couples where both spouses are working may not want to take this allowance to avoid overpaying taxes), have a dependent, or are the head of household (a status for single adults caring for a child or another qualified person). These allowances are not arbitrary - they correspond to parts of the tax code that lower your tax liability, such as a lower tax rate if you are married or the head of household and exemptions, which are deductions you can take for each person, including yourself, that is supported by your income.
Deductions and Adjustments Worksheet
Many people just fill out the Personal Allowances Worksheet and ignore this section, which can lead to excessive withholdings.
The Deductions and Adjustments Worksheet is intended for people who itemize their deductions, have adjustments to income, and/or claim credits. Since deductions, adjustments, and credits reduce your tax liability, this worksheet allows you to reduce the taxes coming out of your paychecks and avoid getting a large refund.
While deductions, adjustments, and credits all reduce the taxes you need to pay, they work differently. Deductions are expenses you can use to reduce your taxable income. Examples of deductions include mortgage interest, property taxes, charitable contributions, and, to a certain extent, medical expenses. On your tax return, you can choose either the standard deductions, a specific amount set by the IRS, or the itemized deductions, what your expenses actually are. Adjustments lower both your taxable income and your adjusted gross income, which is used to determine whether you qualify for certain tax benefits and how much you can claim for some deductions. IRA contributions, alimony payments, moving expenses (in some circumstances), and student loan interest payments are common adjustments. Credits reduce the amount of taxes you need to pay dollar for dollar. Credits are given for, among other things, paying for childcare, having children, paying for college or adult education, having income beneath a certain limit, and adopting.
When you fill out the worksheet, you will have to put down specific amounts for your deductions, adjustments, and credits for the year. You may already know what they are, or you may have to do some research or estimate. For expenses you cannot be certain of until the end of the year, such as medical costs, try to be conservative. If you overestimate, you may wind up owing. If you are claiming credits, you will need an additional form, “Converting Credits to Withholding Allowances”, to figure out what to put on your Form W-4. It is available on the IRS’s website. Since taxes are not collected on a pay-as-you go basis for non-wage income, such as dividends and interest, if you have any of this income, it is recommended that you subtract it from your deductions, adjustments, and credits, to avoid claiming too many allowances. Once you fill out the worksheet, it will tell you if you have enough deductions, adjustments, and credits to claim more allowances.
Two-Earners/Multiple Jobs Worksheet
This worksheet is intended to help individuals who work multiple jobs and dual income married couples make sure that enough taxes are being withheld from their paychecks. The Deductions and Allowances Worksheet allowed you to add allowances to the ones you claimed in the Personal Allowances worksheet. The Two-Earners/Multiple Jobs Worksheet does the opposite – you deduct allowances. The worksheet contains a chart that shows you how many allowances you should deduct based on your incomes. If your incomes are high enough, it is possible that not enough taxes will be withheld even if you claim zero allowances. While you cannot claim less than zero allowances, you can choose to have an additional dollar amount withdrawn from each paycheck. The worksheet can help you figure out the appropriate amount. You can have it deducted from the job of your choosing, although the IRS suggests claiming all of the allowances for the highest paying job and zero allowances for the others.
Filling out your Form W-4 so that your paycheck withholdings correspond to your tax liability may be time-consuming, but it can help you to avoid “lending” or owing the IRS a lot of money. Still, Form W-4 is only a guide – it cannot guarantee that your withholdings will exactly match your actual tax liability, especially if your situation changes during the year. Having savings makes paying periodic and unexpected expenses, such as tax bills, easier. If adjusting your withholdings results in a higher take-home pay, why not put that extra money in savings?
*This publication is only intended to be used for general informational purposes. Consult a tax professional for personal advice.
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