Managing your taxes is as much about planning for next year as it is about completing and filing your taxes this year. Life does not stop. Your income or deductions may change, but you can always adjust your tax withholding to avoid receiving too large a refund or, worse, having to pay a large balance to the Internal Revenue Service (IRS) at tax time due to tax debt.
Finding the right level of withholding tax can be a balancing act, especially if big changes are expected in the coming year or personal events with tax implications, such as a marriage, divorce, or having a child. An understanding and a few general rules of the process can help.
Why would a tax refund be a bad thing?
Getting a tax refund means you've given the IRS more than you owe on your paycheck, the money you could have spent on bills, hobbies, retirement savings, or investments. The IRS has withheld this extra money for you throughout the year. It is simply repaid when you receive an interest-free tax refund. It would have served better in a simple savings account.
The Withholding Form
Sometimes, calculating an appropriate level of withholding can take as long as preparing a tax return. But the IRS has introduced a new W-4 form beginning with the 2020 tax year, which might simplify the process. It complies with changes made by the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA eliminated the personal exemption, which was tied to allowances that could be claimed on the old form.
The new form aims to simplify the process. It uses a question-answer format, thereby allowing you to adjust your withholding upwards or downwards.
You may have more withheld from your payroll to cover at tax time if you anticipate significant investment income or have other outside income that is not subject to withholding tax. You will be refunded if you have too much withheld. You owe the IRS when you file your tax return, and you may also face a penalty if you adjust the withholding amount too far downward.
Note: It is usually enough to pay at least 90% of the tax due to escape the estimated tax penalty.
Calculating the withholding more accurately
One way to adjust your withholding tax is to prepare an estimated tax return for the year. Use the same tax forms you used last year, but replace this year's tax rates and income brackets. Calculate your income and deductions based on the income you expect this year. Use current tax rates to determine your tax estimate.
Then use the withholding tax calculator on the IRS website to see the suggested withholding tax for your personal situation. The number of income streams and dependents you have is an important part of your analysis.
Don't want to make mistakes? Get the help of a tax professional, as they know exactly what to do.
Calculating the effect on your Paychecks
When calculating your withholding tax, you can use the number to estimate what the tax effect will be on your next paycheck. Enter your newly calculated tax withholding information into a payroll calculator. Make sure you have a recent paycheck on hand so you can use your actual earnings.
Calculating your total withholding for the year
Take the new deduction amount for the pay period and multiply it by the total number of pay periods that are left in the year. Next, add how much federal income tax has been withheld. This total is approximately the total amount of federal tax withheld from your paycheck for the year.
Summary
Getting a withholding tax refund means the IRS returns your money to you without interest. But you also don't want to be in debt at tax time.
The IRS has revised the old Form W-4 to reflect changes made by the TCJA. This version makes the completion process much easier with lots of instructions and tips.
The IRS offers several online tools you can use to make your tax withholding as accurate as possible based on your income, expenses, and personal circumstances.
You can change your withholding at any time. You are not limited to an annual deadline.
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