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The What’s, Why’s and When’s of Withholdings

Kara Feuerborn, CPA

Director of Financial Education

Last Updated
January 27, 2022

The What’s, Why’s and When’s of Withholdings

Welcome to tax season. Yes, it’s that time of year again. You may be telling yourself that this year will be different. Maybe you’ve received all your W-2s and 1099s and have already totaled up your deductions for the year. Perhaps you’ve even sent your forms to your accountant or plugged your numbers into your online tax preparation software. Now it’s time to sit back and wait for the tax refund to roll in, right?

Not so fast. Even if you’ve done everything right in preparing your taxes, you could be in for a shock come tax time if you recently started a new job and improperly completed your W-4. Electing the wrong withholding amount could mean you owe money to the IRS at the end of the year or, even worse, you may owe a penalty as well.

Like many tax-related issues, accurately completing your W-4 can be more complicated than it seems. If you want your withholdings to be accurate, it’s important to provide more information than just your spouse’s wages and number of dependents. This is where many taxpayers get it wrong.

What is the W-4?

Before we get into tips on how to complete the W-4, it makes sense to review the purpose of this tax form. The W-4 provides an opportunity to pay toward your estimated tax liability prior to the tax filing deadline. The federal withholding amount deducted by your employer is estimated based on the information you provide about your entire tax return. The only information your employer has to help determine how much to withhold is what you provide on your W-4. If you have taxable investments, self-employment income from a side gig or other earned income that is not reported on your W-4, you may owe additional taxes at the end of the year.

Other examples of income taxpayers often neglect to include on their W-4s include:

  • Interest income
  • Dividend income
  • Capital gains
  • Self-employed business income/independent contractor income
  • Rental income
  • Royalty income
  • Passthrough K-1 income from partnerships and S-corporations
  • Farm income
  • Other taxable income received throughout the year

Tips for completing the W-4

If you want your employer to be able to more accurately withhold taxes from your paycheck, you’ll need your W-4 to account for any income earned outside of your job. The following tips can help.

  • Remember that the W-4 is an estimate only. W-4 withholdings rarely equal the exact amount a taxpayer owes in taxes. Because federal taxes operate on a “pay-as-you-go” basis, you must pay a certain amount of your total tax liability each quarter in order to avoid an underpayment penalty when you file your tax return. The amount withheld from your paycheck goes toward making these payments on time so you don’t have to write a check by the due date. Anything not covered by these withholdings will be your responsibility to pay at tax time.
  • Consistency is key. If the only income you earn throughout the year comes from your salary, the W-4 likely provides an accurate estimate of the amount of taxes you will owe. However, if you have fluctuating income or deductions in addition to your wages, the appropriate withholdings become more difficult to calculate.
  • Consider making changes earlier in the year. Making changes later in the year leaves fewer paychecks from which to withhold taxes. Adjust your withholdings early in the year so a smaller amount can be withheld from each paycheck.
  • Complete a withholding check-up part way through the year. Part way through the year, check in on your withholdings to make sure you’re on track. Estimate your total upcoming tax bill and compare that amount with your year-to-date and remaining withholdings to determine if the amount withheld will be enough to foot the bill. (Your wealth manager can help with this.)
  • Rethink your filing status. Instead of choosing a filing status based on your marital status, consider using this box as a way to adjust the amount withheld. Following is a breakdown of how your filing status can impact your withholdings.
    • Selecting the “single or married filing separately” option will withhold the most taxes. You can select this box even if you are married and filing a joint return. It may make sense to select this option if both spouses work, as it can help reduce the amount you owe at the end of the year.
    • Selecting the “married filing jointly” option will withhold less in taxes, as it assumes your spouse doesn’t work and you will have less tax liability at the end of the year.
  • Rethink your dependents. If you wish to increase the amount your employer withholds, you don’t need to claim your dependents. Simply leave this section blank.
  • Keep it simple. If your tax return is more complex than just wages and consistent income, consider making a quarterly estimated payment for any amount above your withholdings. While it may seem like you are paying more when you write a check, you’re really just covering the extra amount that would be due at the end of the year.
  • Revisit your W-4 if you receive large refunds each year. While it may be nice to receive a big refund come tax time, that’s technically your money the government is hanging on to for part of the year. It’s better to break even, or even owe a bit, when you file in order to make the most of any potential investment returns on that money throughout the year.

Again, it’s important to remember that the W-4 provides an estimate of what your employer should withhold from your paycheck each pay period so you either owe nothing or owe less to the IRS come tax season. It’s up to you to make sure you pay at least 90% of your current-year tax liability or 100% (110% for higher income earners) of the tax shown on your prior year’s return, either through payroll withholdings or estimated tax payments. If your withholding doesn’t cover your tax liability, you can either modify your W-4 to withhold more or remit a separate estimated tax payment for the remaining amount due. Both payments go toward your total tax bill for the year.

Your wealth advisor and tax preparer can help you review your W-4 and additional income now so you can be more prepared come tax season.

At Creative Planning, we deliver a team of credentialed, educated, experienced and action-oriented advisors, including CERTIFIED FINANCIAL PLANNER™ practitioners, certified public accountants, insurance specialists, attorneys and other professionals dedicated to helping you achieve your financial goals. If you need help adjusting your W-4 withholdings, or for any other financial matter, please schedule a call.

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This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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