As advisors, we are often asked about the concept of a W-4. How much should I withhold? What is an allowance? How often should I update my W-4? With all of these questions in mind, this blog will address this important form and the logic behind accurate withholding choices.
Withholding tax (also known as “payroll withholding”) is income tax that is withheld from your wages and sent directly to the IRS by your employer. In other words, it is like a credit against the income taxes you must pay for the year. By subtracting this money from each paycheck, the IRS is withholding anticipated tax payments as you earn it. At tax filing time, income, deductions, and tax withholdings are calculated together on your tax return. The result is either a refund to the taxpayer or a payment owed to the IRS.
While everyone likes to get a tax refund, you should keep in mind that you are only getting back the money you earned that year. A tax refund is basically an interest-free loan that you gave to the IRS! You have probably heard this many times. On the other hand, if too little is withheld from your wages, you will likely owe more tax at the end of the year because you have underpaid the IRS. Additionally, you may be subject to penalties and interest charges for under-withholding. For most taxpayers, it is recommended that you try to match your withholding tax as close to your actual tax liability as possible. While you cannot avoid paying taxes altogether, you can control the amount that is withheld from each paycheck when you fill out your W-4 form.
To understand Form W-4, you must understand allowances. Think of allowances as cash in your pocket at the time that you receive your paycheck. The more allowances you claim, the smaller amount of tax taken from your paycheck, and the more you take home in pay. For example, you can maximize the amount withheld from your paycheck to ensure that you have enough tax withheld to cover tax liabilities by claiming zero allowances. This will reduce the amount of cash you take home in your paycheck. The following factors will determine your number of allowances:
- The number of personal and dependency exemptions that you claim on your federal income tax return
- The number of jobs that you work
- The deductions, adjustments to income, and credits that you expect to take during the year
- Your filing status
- Whether or not your spouse is employed
The purpose of Tax Form W-4 is simple. It is used by your employer to withhold the proper amount of federal income tax from your paycheck. As advisors, we recommend that employees submit a new W-4 tax form each year, or any time their personal or financial situation changes. Keep in mind that some life events result in more taxes, while others entitle you to credits and deductions that lower your taxes. A few of the most common events that would warrant a review include getting a second job, making more money, getting married or divorced, having or adopting a child, being unemployed for a part of the year, or experiencing a job change in the family.
The number of allowances you claim on a W-4 will ultimately determine your take home pay and will impact your future tax liability. Take the few extra minutes to really assess your situation and fill in the W-4 accordingly. A great tool to help is the IRS Withholding Calculator, located on the IRS website. By taking the time to understand withholdings, you are setting yourself up for a strong financial year. Do not miss out on that opportunity!