With more and more taxpayers moving to temporary or gig work, experiencing inconsistent or multiple income streams and without an HR department to help determine the appropriate amount of tax they’ll need to pay, frequently estimating the amount of tax due is not only a good practice, but almost a necessity.
Even if you work for a traditional corporation with an HR team, you may want to confirm your Form W-4 and make sure you’re having enough withheld. Or, you may be a careful planner and budgeter of your monthly salary (hats off to you!) and calculating the tax you’ll owe and comparing it to what is actually withheld is a smart exercise.
Whatever the reason, no one likes a nasty surprise when they file their federal taxes. In the extreme, having too much withheld and getting a large refund can be just as bad as not having enough withheld and being forced into writing out a big check.
How to Get Started
For most of us, the easiest way to determine the monthly federal tax due is to think about it annually and then divide it by 12. This exercise can be conducted every few months just to make sure you haven’t missed any significant changes and to keep up with any seasonal or temporary work changes that you didn’t anticipate.
To facilitate your efforts, an easy web search will get you to several sites that don’t cost anything – and plenty that do – that offer tax and budgeting software. Depending on how complicated your personal financial situation is, the key information can be easily updated and won’t take too long.
Finding Your Gross Salary
Whether you choose to prepare your taxes manually or through software, the steps and information needed are the same. The first step is to estimate your gross earnings. That is, your earnings before any deductions.
If you’re paid an annual salary, this is pretty easy. If you’re hourly, estimate the number of weekly and monthly hours you’ll work and multiply by your wage rate for the year. Remember to estimate and add in any bonus and overtime pay. If you hold more than one job, work seasonally or are a gig worker, the fluctuations and uncertainty may make this step a little harder, but do your best and estimate your annual earnings.
Estimating Pre-Tax Deductions
The next step is to estimate the deductions that reduce your gross earnings before considering your tax calculations. Potentially there are several, including FICA (Social Security tax and Medicare tax), and depending on where you live, various state insurances for disability, unemployment, workers comp and so forth. These are not discretionary, are deducted by law and most are deducted as a percentage of gross earnings. Some have limits based on your income and filing status.
In addition, there are several discretionary deductions that reduce your gross earnings before considering tax. These would include some or all of the following: 401(k) contributions, medical/dental/vision insurance, disability and life insurance, deductions for a Health Savings Account (HSA) and Flexible Spending Account (FSA) and maybe a commuter account. These deductions are designated in absolute amounts and easy to determine based on plans you’ve signed up for.
Calculating Your Net Income
After subtracting these various pre-tax deductions from your gross earnings, you’ll be left with your net income. In tax terminology, this would be the amount that would show up on Line 1 of your 1040 tax return.
Get Your Adjusted Gross Income
There can be a number of additions or reductions to your income depending on your personal situation and things like whether you are self-employed and have various business expenses and taxes, whether you own property that you rent out, if you have a bank account that earns interest and other investments that pay dividends, whether you’re directly contributing to an IRA or not and so forth. These adjustments are captured varyingly on IRS Schedules 1, 2, 3, which are in turn supported by sub-schedules like A, C, D, E and so forth.
These various adjustments when added and/or subtracted result in your adjusted gross income (AGI).
Schedule A or Standard Deduction?
After arriving at your AGI, you need to determine if you have enough additional expenses that make it worthwhile to itemize them on a Schedule A or not. These expenses include medical costs not covered by insurance, personal income taxes you paid to your city and state of residence, interest you pay for the mortgage on your home, donations you make to your favorite local charity and some others.
The reality for most taxpayers is that the standard deduction is going to be more favorable than the expenses you could document on a Schedule A. When the 2017 Tax Cuts and Jobs Act was signed into law, it simultaneously reduced the amounts of these expenses that could be deducted and nearly doubled the standard deduction. Now it is estimated that only about 13.7 percent of taxpayers have sufficient expenses to make it worthwhile to complete a Schedule A and ignore the standard deduction.
Taxable Income and Federal Income Tax
Whether you take the standard deduction or itemize, when netted against your AGI, you reach taxable income. You can determine your tax from the IRS instructions. If your taxable income is less than $99,000, you’ll use the tax tables, and if your taxable income is more than $99,000, you’ll use the tax calculation worksheets.
Getting Tax Credits
Your tax may be reduced for certain credits including the Earned Income Tax Credit, excess Social Security tax withheld and others.
Is Enough Tax Being Withheld?
Now comes the moment of truth. After reducing your tax due by any qualifying credits, you can compare the tax due to the tax your employer has withheld or, if you’re self-employed, the amount of tax you have paid. If the tax you calculated is greater than what has been withheld, then you may consider increasing your withholding.
Some people like to withhold less than they know they will need to actually pay because they want to hold onto their money until the tax filing deadline (usually April 15 of the following year). Other people like to have too much withheld so they can get money back from the government, as they view it as forced savings.
If you prefer to owe the government, be careful because the IRS can impose a penalty and interest if the amount withheld is less than the amount due. To avoid this penalty, the taxpayer must either owe less than $1,000 or less than 10 percent of the total tax due, or have paid at least 100 percent of the previous year’s tax.
Back to Monthly Calculation of Tax Due
Even for taxpayers with the simplest of financial situations, the process of determining the tax due just once a year can be daunting, let alone monthly for a self-employed taxpayer with multiple sources of income, a house they’re renting out, children and living in a high-tax city and state.
But with plenty of available tax estimation software options and the simpler process resulting from the passage of recent tax overhaul legislation, a periodic monthly or quarterly analysis is possible and a good idea.
- IRS: Credits and Deductions for Individuals
- IRS: About Schedule A (Forms 10040 or 1040-SR), Itemized Deductions
- Tax Policy Center: How Did the Tax Cuts and Jobs Act Change Personal Taxes?
- IRS: About Form 1040, U.S. Individual Income Tax Return
- Forbes: The Six Best Tax Software Programs of 2020
- IRS: FAQs on the 2020 Form W-4
- IRS: Gig Economy Tax Center
- IRS: Topic No. 306: Penalty for Underpayment of Estimated Tax
- IRS: Tax and Earned Income Credit Tables - 2020 Draft
- Tax Foundation: How Many Taxpayers Itemize Under Current Law?
Alan Kearl has overseen the commercial, operations and finance areas at the C Level for several leading beauty industry brands. He is a board member, a business consultant and writer. He has an undergraduate degree in Economics from Brigham Young University, and an MBA in Finance from the Krannert School at Purdue University. He's recently been published by Business Insider. You can connect with him on LinkedIn.