The IRS and many state tax authorities operate on a “pay-as-you-go” system. This means you need to make sure you’re paying the right amount of taxes throughout the year as you earn or generate income.
If you pay too little, you could be subject to interest and penalties. If you pay too much, well, you’re just loaning the tax authorities money that you could have been using throughout the year which is less than ideal.
This is where proper tax withholding comes into play.
Whether you’re a retiree receiving various sources of income, small business owner, a freelancer, or simply an individual looking to improve your financial well-being, we’ve got you covered.
Understanding Tax Withholding
When referring to tax withholding, we are referring to income taxes only. Income taxes are what you owe the federal government i.e., the IRS, and possibly your state, if your state imposes an income tax.
When referring to income tax withholding, we are not referencing what are called payroll taxes such as Social Security and Medicare, unless you are self-employed.
Income tax withholding is the amount of money that is automatically deducted from your paycheck by the institution from which you are being paid. So this might be your employer if you get a W2 each year, a pension you receive in retirement, withdrawals from retirement accounts such as IRAs and 401(k)s, or possibly even Social Security benefits.
When you look at your pay stubs, you’ll see “Federal Income Tax Withholding” and possibly “State Income Tax Withholding” listed as a deduction from your taxable earnings.
These amounts are withheld and sent to the tax authorities throughout the year to cover your anticipated tax liability. The amount withheld depends on various factors such as:
- Your total household income
- Your filing status (Single/MFS, MFJ/Qualified Surviving Spouse, or HOH)
- Potential deductions and credits you might be claiming on your tax return, and
- Any additional withholdings you may have requested.
There are many income sources where there actually is no way to automatically withhold and pay taxes as you go. You might be familiar with this if you are self-employed, have income from rental properties, or maybe you live off of dividends or interest from sources like stocks and bonds in a brokerage account.
You might even receive payments from a note or an installment sale of some sort. In situations like this, the tax authorities still expect you to pay-as-you-go, so you’ll need to be prepared to handle that in a different manner.
Why Adjusting Tax Withholding Is Important
Tax withholding is one of those tedious areas of tax planning for most people since the technical process of making changes per your unique situation isn’t very straight forward. There are many ways you could go about it, and often times it’s not something that your tax preparer is going to hound you on throughout the year.
Most professional tax preparers won’t make these adjustments for you either unless you specifically ask them to. Typically, their main focus is simply to prepare your return (if they have a large practice with many clients), and that is of course if you even use a tax preparer.
For those of you preparing taxes on your own, you might find this as one of your major pain points and may struggle to get right. This is especially true if you have multiple sources of income.
Understanding how to adjust tax withholding per your specific situation is absolutely key to optimizing your finances and personal wealth building machine. More specifically, your ongoing cash flow throughout the year.
By strategically adjusting your tax withholding, you can avoid overpaying taxes throughout the year (and receiving large refunds the following year) and instead use that money to your advantage to help you leverage the money you work so hard for.
By avoiding overpayments you will keep more money in your pocket throughout the year, allowing you to use that extra cash for other purposes such as:
- Building up your emergency fund
- Paying off debt
- Investing, or
- Saving for other future financial goals or planned expenses
Sure, even if you overpay throughout the year, you can still of course use your refund come tax time for some of those same goals. However, due to the time value of money you will be still losing out on potential growth that money might have provided, or even just to ease the burden of monthly bills throughout the year.
Overpaying and receiving a large refund the following year is not ideal. Receiving a refund is not an indication that you have a “good” tax situation or have done good planning.
The most basic way to put this concept into perspective is by understanding the impacts of time value of money. This principle essentially means that a dollar today is worth more than a dollar in the future.
This is true because a dollar today can be invested or put to work to produce a potential return and potentially be worth more in the future.
Potential Uses for Extra Cash Flow
You might adjust your tax withholdings so that you take home more money each paycheck and use that to pay down interest bearing debt.
The more frequently you make these extra payments towards debt principal, the smaller your balance becomes and the less you will be charged interest on moving forward.
This is opposed to waiting all year for your tax refund, getting charged interest on a higher balance, then paying it down in a big lump sum.
On the other hand, you might use it to build up an emergency fund faster. This can allow you to go back and review other components of your finances such as your your auto and homeowner’s insurance policies to consider increasing your various deductibles.
This typically results in lower ongoing premiums and can free up even more cash flow on a monthly basis!
If you’re serious about building wealth, one of the best uses for your extra cash flow is to invest it wisely. There are numerous benefits to investing on a more frequent basis over time. The most notable benefit comes from dollar-cost averaging which can reduce investment risk.
Regardless of how you choose to deploy your extra cash flow, you need to have a set plan with definitive goals. Without a plan, that money will likely end up being another one of those “black hole” expenditures.
Underpayment of Tax Liability
Another major reason adjusting your tax withholding is so important is to avoid substantially underpaying the tax authorities.
Underpaying throughout the year via your withholdings can cause penalties – which is essentially more taxes. You may be assessed penalties even if you are due to receive a refund.
And to make matters worse, not only are you charged interest on taxes not paid on time, but the IRS and some states also charges interest on any accrued penalties and interest themselves!
The good news is that avoiding penalties is something you can control when it comes to your tax situation, and that keeps more money in your pocket, so why not make sure you have control?
As if you aren’t already squirming about paying interest on your accumulated interest and penalties, the current interest rates the IRS imposes are typically quite hefty and they compound daily.
The interest you’ll owe is likely more than the interest your cash can earn in the bank, and likely more than what your cash might be able to earn in low risk investment instruments such as high yield savings accounts and CDs.
And just so you’re aware, there are certain criteria that you might meet that don’t call for any underpayment penalties to be owed. It’s best to reach out to a tax professional if you’re concerned about owing penalties or have consistently incurred them in the past.
In addition, you can avoid underpaying your tax liability and mitigating or even eliminating potential penalties for doing so.
Factors to Consider When Adjusting Tax Withholdings
Various factors, such as changes in income, filing status, and life events, can impact your tax liability. Understanding these factors and how they affect your withholding can help you make informed decisions when adjusting your withholding.
First and foremost, you need to have a clear understanding of your current financial situation.
Start by taking a look at your income, expenses, and on your most recent tax return for your previous year tax liability and any deductions or credits you may be eligible for.
This will give you a better idea of how much your tax liability may be by the current year-end and therefore get you in the ballpark of what you should be withholding to ensure you’re not substantially underpaying or overpaying your taxes.
When looking at your paystubs, you’ll need to be mindful of what amount is being taxed and what isn’t. If you’re still working, there will likely be a portion of your pay that isn’t being taxed.
Some examples might be certain fringe benefits your employer offers or contributions to a retirement account such as a 401(k), 403(b) or 457 plan.
Your tax withholding should be reflective of your taxable income, so you wouldn’t include any pre-tax deductions when determining your withholding. If you’re married, you’ll also want to understand what your spouse is withholding from their pay.
Additionally, you’ll want to consider any changes that may have occurred in your life currently that could impact your tax liability this year, and or next year.
Some examples are:
- Have you recently gotten married or divorced?
- Did you have a child?
- Do you now have a dependent grandchild?
- Did you start a new job or receive a significant raise in pay?
- Are you expecting a bonus later in the year?
- Are you planning on exercising any equity compensation awards ?
- If you are going to retire, are you going to be receiving any lump sum payments at retirement?
- Will you continue to work but your spouse is retiring?
- Did your spouse pass away during the year?
- Did you start a small business or side hustle?
These types of events will likely affect your tax situation, sometimes significantly. It’s important to adjust your tax withholding accordingly to avoid any surprises when it comes time to file your taxes.
If you are going to experience any of these types of changes, you’ll want to understand where to begin when adjusting your tax withholding.
Retirement income
If you are going to retire with a pension, you will go from receiving a W2 tax form to a 1099 tax form to report the income.
This might mean that you will now have to fill out what is called a Form W-4P for pensions and annuity payments. Some pension providers may have their own unique forms for you to fill out.
Regardless of what form is required, don’t assume that the withholding you put on your Form W-4 while working will carry over or be accurate given your new circumstances.
You will likely need to adjust your tax withholding in a situation like this since often times the amount you receive in a pension won’t be the same as you received while working.
In addition, you won’t have certain pre-tax deductions on your pension payments for things like certain fringe benefits or retirement plan contributions, which will change your tax situation as well.
If you inherit retirement accounts, you will likely be subject to required minimum distributions (RMD) and may need to make sure you withhold the proper amounts on each of those distributions when taking them.
Social Security
Another common situation to be ready for is when you start receiving Social Security Benefits. Although not mandatory, you can choose to withhold from Social Security benefits.
A lot of people get tripped up by this because they assume it will be taken care of for them when it’s actually quite the opposite.
The Social Security Administration (SSA) will not help you determine any tax withholding and won’t force you to withhold. Many people find out they will owe additional taxes after their first year of receiving benefits and are shocked to see their new tax bill.
Don’t let that be you. There is a special form to set up your tax withholding from your Social Security benefits called Form W-4V. You will need to fill this out and submit it to Social Security yourself.
After submitting, be sure to review your future pay stubs to ensure the withholding adjustment has been processed.
Inheritance
Other not so obvious situation that you will want to be aware is when you are the beneficiary of a sizable inheritance and you turn around and invest the cash, or generate some sort of income.
Depending on how you invest this money, you may end up earning interest or dividends that will be subject to taxes each and every year.
You may need to account for this income and pay taxes through what are called estimated payments.
The concept is similar if you inherit an investment property and continue to rent it out.
Small Business
Lastly, if you start a business, you will want to work with a professional to help you get an idea of the kind of profit you might turn out and whether or not your need to make estimated tax payments.
This is especially true if you also have other income sources in addition to any potential business profits.
How to Determine the Correct Federal Tax Withholding Amount
Adjusting your tax withholding, especially on the various required forms, can be a bit tricky and time consuming.
The current forms used to adjust withholdings from a paycheck or pension can be confusing to many people due to the tax jargon used on the forms and notably the lack of withholding detail regarding the check boxes on the W-4 forms in Step 1.
The good news is that there are several resources available to help you navigate the process and do some of the calculations based on your own situation.
IRS Withholding Calculator
The IRS actually provides a withholding calculator on their website that can assist you in determining the appropriate amount to withhold from your paycheck.
This calculator takes into account your income, deductions, and credits to give you an estimate of your tax liability for the year. It can also include income earned through other jobs or businesses you or your spouse may have. The calculator is meant to help you fill out the common W-4 forms to provide to your employer or institution.
NOTE: After helping countless people with their withholdings over the years, we hesitate to go off of this calculator because it’s time consuming and most professionals have more sophisticated methods and software that are better in our opinion. But if you’re going at it alone, it can still help you significantly.
Consider Consulting a Professional
You might instead choose to instead consult with a tax professional or properly licensed financial advisor who can provide personalized guidance based on your specific financial situation.
A professional can help you with the initial heavy lifting when it comes to analyzing your taxable income, expenses, potential credits and deductions, and the other relevant factors we’ve discussed to determine the optimal withholding or estimated payment amounts and how to submit or make any estimated payments.
What’s more important, they can help you develop a good strategy for what to do with any potential additional monthly income you might take home as a result.
Steps to Adjust Federal Tax Withholding
Adjusting your tax withholding is a relatively straightforward process, but that doesn’t mean it’s necessarily that easy.
Still Working
If you’re still working, the first step is to complete a new Form W-4, which is the Employee’s Withholding Certificate.
Form W-4 will essentially calculate a withholding amount based on your filing status and certain deductions or credits you will be claiming on your tax return.
This form is typically provided by your employer (or can be found online) and allows you to update your withholding information. It is important to know that this form is to be provided back to your employer, not the IRS.
Even though it is an IRS form, this is a common misconception many people have. On the form, you’ll need to provide your personal information, such as your name, address, and Social Security number, as well as your filing status.
The form includes basic instructions on how to fill it out.
While we will not discuss every nuance of how to fully prepare an accurate W-4, we will provide you with some guidance and tips to help you navigate the process
Step 1, Part C
One notable component of the Form W-4 is in Step 1, Part C where you will need to check the appropriate box for your filing status.
By checking one of the available boxes, a certain amount of taxes will be withheld from each paycheck based on your filing status, tax rates, and the standard deduction.
In order to get an idea of the actual dollar amounts that will be withheld from your paychecks as a result of Step 1, Part C, refer to the tables here: IRS Pub 15-T
When reviewing the tables:
- See “Wage Bracket Method” Sub-Heading
- Refer to the frequency of your payroll (i.e., bi-weekly, monthly, semi-monthly, etc.)
- Refer to taxable amount you earn per pay period and applicable filing status
Steps 2-4
If you have multiple jobs or are married and your spouse also works, you will be able to account for this in Step 2, and by using the IRS calculator or by using the worksheets included with the Form W-4.
If you claim dependents such as children or other dependents on your tax return there are adjustments you can make to account for this in Step 3.
If you will not be taking the standard deduction on your tax return and will instead be itemizing deductions, or you simply want an extra dollar amount withheld per pay period, you can make the necessary adjustments in Step 4.
Pro Tips:
If you are finding yourself with a big tax liability each year and having to come out of pocket come tax time – meaning you are underpaying and need to withhold more – you might consider using the section titled “extra withholding” and simply listing the additional dollar amount you want withheld each pay period.
This is opposed to going through the other methods on the form which may prove to be more complicated and time-consuming.
In order to do this, you will want to have a good idea or projection of the extra amount you’ll owe given your tax situation this year.
You can get an idea of this from your tax professional or by doing your own projection if you do your taxes yourself.
On the flip side, if you need to reduce your withholding by a specific dollar amount because you get fairly consistent refunds each year, it’s a little trickier.
There is no line that specifically asks you what you want to reduce your withholding by. However, one option is to use line number 3 in Step 3 where it asks to put in the amount of any tax credits you might expect to receive.
Although you may not actually be expecting any specific tax credits, an amount put here will reduce your withholdings dollar-for-dollar as if it was a tax credit.
NOTE: Actual tax credits reduce your tax liability dollar-for-dollar.
This is basically a work around. The key detail here is that the amount you put here is an annual dollar amount, not per-pay-period like the extra withholding line discussed above.
Therefore you’ll want to do the math on how many pay periods are remaining for the current year and back into the number.
Retired or Semi-Retired Receiving Pension or Annuity Payments
If you’re receiving a pension, it’s a similar process but you will typically use Form W-4P instead of the standard From W-4.
The process of filling out the W-4P form is nearly identical to the standard W-4.
Social Security Withholding
Social Security and even unemployment compensation withholding is done with Form W-4V.
The W4-V only allows certain percentages to be withheld which are currently: 7%, 10%, 12%, 22%, or you can have them stop withholding entirely.
Make sure you have a good understanding of your tax situation and overall income sources. In some cases, your Social Security may not be taxable at the federal level based on your income. In this case you would not submit a Form W-4V at all.
While the form is more simple to understand and fill out compared to the other W-4 forms, it is less flexible depending on your situation.
Small Business Owners
If you have a business, the structure of your business will determine how you pay the taxes.
Generally speaking, if you are a sole proprietor (even if you’re a sole proprietor with an LLC), you will pay your taxes from your personal bank account since the business income flows through to you at the end of the day.
You don’t need to make the tax payment from the business account.
What you will want to be aware of is the fact that you will be subject to self-employment tax in addition to federal and possibly state income tax.
Self-employment tax is essentially your payroll taxes owed to Social Security and Medicare.
Since there is no W-4 form if you’re a sole proprietor and you are not issuing yourself a W-2, you will need to pay both self-employment taxes and income taxes via quarterly estimated payments.
There is not a separate voucher or form for each, you simply make your total payments between the two types of taxes with each quarterly estimated payment.
If on the other hand you have an LLC taxed as an S-Corporation, you will likely receive part of your income as a W-2 wage if you also take distributions of profit from your S-Corporation.
Because of this nuance, you will have a W-4 for the wage portion of your income and may need to make estimated payments for the portion that is the net profit of the S-Corporation.
This is regardless of whether or not you take the profits out of the business bank account.
In other words, even if you don’t take any profits out of the business, you are still taxed on that profit in an S-Corporation.
The S-Corporation profit flows through to your personal tax return each year, so again, you would pay any taxes owed personally and don’t need to pay them from the business bank account.
If you did pay the taxes from the bank account of the business, you are just making your bookkeeper’s job a bit more complicated.
Tips like using the Extra Withholding section on the W-4 form for consistent underpayments or leveraging tax credits to reduce withholding can help tailor your withholding to your needs.
Consider making estimated quarterly tax payments if you prefer a more straightforward approach to managing your tax obligations.
Exemption from Tax Withholding
While most people need to have tax withholding, there are situations where you may be exempt.
One possible mistake you want to avoid making is withholding when you actually have an exemption from withholding in the first place.
Under certain circumstances, you may be able to claim an exemption from withholding, and if you do so, your employer will not withhold federal income tax from your wages.
The exemption applies only to income tax, not to Social Security or Medicare tax which are payroll taxes.
Being aware of these exemptions can help you avoid unnecessary withholding and manage your cash flow more effectively.
Generally, you can claim exemption from withholding if both of the following circumstances apply to you:
- You had a right to a refund of all federal income tax withheld because you had no tax liability the previous year; and
- You expect a refund of all federal income tax withheld because you expect to have no tax liability for the current year. – remember you need to meet both of these circumstances.
If you determine that you qualify to be exempt, you must give your employer a Form W-4 filled out appropriately.
In situations like this, if the IRS determines that you do not have enough withholding, the IRS will notify you to increase the amount of tax withholding by issuing what is called a “lock-in” letter, specifying the withholding arrangement permitted for you.
You can then send in an updated W-4 to your employer to self-correct the issue.
If you don’t correct it, the IRS will force your employer to start withholding more.
It’s important to note that an exemption from withholding is only valid for one year at a time.
You will need to provide your employer with a new W-4 each year to continue your exemption.
Pro Tips:
Note that you are also required to complete and file a new Form W-4 with your employer within ten days if:
- You were claiming to be married, and you become divorced during the year; or
- Any life event occurs that will decrease the number of withholding allowances you can claim.
This can happen if you were once able to claim one of your kids as a dependent on your return and now you are no longer able to. A common example of this is once a child graduates college or they start providing most of their own support.
The Bottom Line
We typically like to take the approach of: “Whatever generates the taxes pays the taxes”.
In a perfect world, you would have separate withholding on all of your sources of income.
However, for most people this isn’t often the case.
Do your best to update your withholding on all sources because if you don’t, you’ll find yourself with a more complicated situation at the end of the day where you are having more taxes taken from “Source A” to pay the taxes generated from income “Source B”.
Then if income “Source A” stops at some point in the future, you need to significantly adjust the others.
Taking control of your finances through smart tax withholding adjustments can have a significant impact on your financial well-being and wealth-building efforts.
By understanding the ins and outs of tax withholding, reviewing your financial situation regularly, and making informed adjustments, you can optimize your cash flow and put your money to work for you.
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Links & Resources
- Form W-4
- Form W-4P – Pensions & Annuity Payments
- Form W-4V – Unemployment Compensation & Social Security
- Estimated Payment Vouchers
- IRS Tax Withholding Calculator
- 2024 – Information for Step 1, Part C of Form W-4: IRS Pub 15-T
Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ and Enrolled Agent located in Riverside and Orange County, CA.
Disclosures:
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.
This information is for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.