If you think back to the first paycheck you received, you were probably surprised to find that the amount of your check didn’t equal the full amount you had earned. Instead of getting all of your wages, your employer held back some of your income to pay for the taxes that you would owe on the money. The amount your employer withholds is determined by the information you provide on your Form W-4. When it comes to your withholding, knowing the correct way to complete your Form W-4 so it is as accurate as possible helps you avoid big surprises when you file your taxes.
What is Withholding Tax?
Prior to World War II, no one paid taxes during the year. Instead, everyone paid their taxes in a lump sum when they filed their income tax return. However, since that time, income tax withholding has become mandatory. You are required to pay your taxes throughout the year, rather than just making one lump-sum payment at tax time. For most people, the pay-as-you-earn requirement is satisfied through income tax withholding from your paychecks by your employer. However, you have to complete your Form W-4 appropriately to make sure that you have a sufficient amount of income tax withheld from your paycheck to meet the IRS requirements. If you don’t file a Form W-4 with your employer, your employer is required to withhold money at the highest rate – as if you are single and claiming no personal allowances.
If you don’t have enough income taxes withheld from your paychecks during the year, you could face interest and underpayment penalties from the IRS. To avoid interest and penalties, you need to meet one of the safe harbors for income tax withholding. First, you won’t owe interest or penalties if the amount of income tax you owe is less than $1,000. Second, you can avoid underpayment penalties if your withholding and estimated tax payments total at least 90 percent of your tax liability for the current year. For example, if this year you owe $12,000 in taxes, you must have paid at least $10,800 in estimated taxes and payroll withholding throughout the year to avoid penalties.
The third way to avoid underpayment penalties is to pay at least 100 percent of what you owed the previous year. But, if you are what the IRS considers a higher-income taxpayer, the bar is raised to 110 percent of what you owed the prior year. You’re a higher-income taxpayer if your adjusted gross income exceeds $150,000 for most filing statuses, or $75,000 if you’re married filing separately. For example, if last year your adjusted gross income was $100,000 and you owed $16,000 in taxes, you won’t owe any underpayment penalties if your withholding and estimated tax payments equal at least $16,000 this year. But, if your adjusted gross income last year was $160,000 and your tax liability was $21,000, your withholding and estimated tax payments must equal at least $23,100 this year to avoid penalties because you’re considered a higher-income taxpayer.
Married Vs. Single Withholding
When you complete your Form W-4 to tell your employer how to figure out how much to withhold from your paycheck, you have the option to choose to have taxes withheld at the higher single rate or the lower married rate. If you’re single, you only have one option – the single rate. If you’re married, you have the option to have taxes withheld at the lower married rate or the higher single rate.
For 2018, if you’re paid weekly and select the single rate, you’ll have 10 percent of your wages between $71 and $254 withheld for taxes, 12 percent of wages between $254 and $815 withheld for taxes and 22 percent of your wages between $815 and $1,658 withheld. If your wages are withheld at the married rate, the taxes are withheld at 10 percent on income between $222 and $588, 12 percent for income over $588 and up to $1,711 and 22 percent for income between $1,711 and $3,395. These rates are applied after accounting for withholding allowances.
For example, say your weekly income is $1,500 after accounting for withholding allowances. If your withholding is at the single rate, you’ll have $236.32 withheld for income taxes. If your withholding is at the married rate, you’ll have $146.04 withheld for federal income taxes. But, remember that higher withholding isn’t always a bad thing. You must have a certain amount withheld to avoid underpayment tax penalties, and if you have too much withheld, you will get it back when you file your income tax return.
In addition to selecting your withholding rate, you’ll also need to select how many withholding allowances you want to claim on your Form W-4. Each allowance reduces the amount of your paycheck subject to income tax withholding by $4,150 per year in 2018. That allowance is divided over the number of pay periods per year. For example, if you’re paid weekly, each allowance you claim reduces your income subject to withholding by $79.80. If you’re paid monthly, each allowance reduces your income subject to withholding by $345.80.
Determining Allowances Claimed
The best way to determine how many allowances to claim on your Form W-4 depends on your personal situation. The IRS website has a withholding calculator that you can use to determine how many allowances you should claim on your Form W-4. You can also use one of the worksheets on the Form W-4 itself to calculate the number of allowances you should claim.
The W-4 has a short form called the Personal Allowances Worksheet that you can fill out to determine the right number of allowances to claim. You can claim allowances for things like filing as married filing jointly or head of household, child tax credits you expect to claim and potential credits for other dependents you will claim, depending on what you expect your income to be. However, if you fit one of the special circumstances, you should use one of the more complex worksheets to determine your withholding allowances.
If you plan to claim a large number of itemized deductions or adjustments to income, or if you expect to have a large amount of non-wage income, use the Deductions, Adjustments, and Additional Income Worksheet to calculate the number of allowances you should claim on your Form W-4. To complete this worksheet, you’ll need to estimate your itemized deductions, such as charitable contributions, state and local taxes, mortgage interest and deductible medical expenses. You’ll also need to estimate the value of the adjustments to income you’ll claim, like contributions to a traditional IRA, student loan interest or educator expenses. Finally, you’ll need to estimate how much income you expect from sources that aren’t subject to income tax withholding, such as interest, dividends or capital gains. For example, say that you expect to earn about $15,000 in dividends and profits from selling stocks this year. No income taxes are withheld from that income, so you need to either make estimated tax payments or have additional amounts withheld from your paychecks to make up for it.
Another situation where you should use a more complex worksheet is if you work multiple jobs or if you are married and both you and your spouse work. In that case, you should use the Two-Earners/Multiple Jobs Worksheet. This worksheet helps you determine the total amount of allowances you should claim for all of your income, or the income of both you and your spouse. When you have determined the number of allowances, you should claim all of them on the highest paying job and claim zero allowances for all other jobs. For example, if you work two jobs and after completing the Two-Earners/Multiple Jobs Worksheet you find you should claim three allowances, you should claim three allowances on your highest-paying job and zero allowances on your lowest-paying job to have your withholding most accurately reflect how much you’ll owe.
Claiming Additional Withholding
You can’t claim a specific amount to have withheld from your paychecks instead of claiming allowances and a filing status. However, you can claim an additional amount of income withheld from each paycheck on top of the withholding calculated by your filing status and your withholding allowances claimed. You can utilize this option if you expect to have a certain amount of additional tax from income sources that aren’t subject to withholding. For example, say you expect to have a $10,000 long-term capital gain during the year that will result in an extra $1,500 of taxes. If you are paid monthly, you could opt to have an additional $125 withheld for federal income taxes each paycheck. That way, over the course of the twelve monthly paychecks you receive during the year, you’ll have a total of $1,500 extra withheld from your paychecks to cover the additional tax due from the capital gain.
Impact of Overwithholding
You’re generally going to be better off if you have too much money withheld from your paychecks than having too little withheld. When you have too much withheld, you’ll receive the excess back in the form of a tax refund when you file your taxes. For example, say you had $12,000 withheld from your paychecks for income taxes. If when you file your return you only owe $9,600, you’ll receive a $2,400 tax refund. The downside to having too much money withheld from your paychecks is that you’re essentially making an interest-free loan to the government. For example, if you have debt that you could be paying off and instead the money is withheld for your federal income taxes, you’ll be paying interest on your loan, but you won’t be getting any interest on the excess that the government is holding until you file your tax return.
How to Change a W-4
If your withholding isn’t adequately reflecting how much you should have withheld, you can file a new Form W-4 with your employer. For example, if you had too little money withheld from your paycheck for the previous year, you can file a new Form W-4 with fewer allowances claimed so that you will have more money withheld in the coming year. Alternatively, if you had too much withheld and you would rather have the money paid throughout the year rather than as a large income tax refund, you can file a new Form W-4 claiming additional allowances. The IRS recommends filing a new Form W-4 whenever you have a major life change, such as getting married or divorced, having a child or picking up a second job.
You can change your income tax withholding at any time simply by filing a new Form W-4. After you submit it to your employer, your employer must start using the new information to calculate your withholding no later than the first pay period that starts at least 30 days after you submit your new Form W-4. For example, if you submit your new Form W-4 on June 1, your employer must start using it for the first pay period starting July 1 or later.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."