At this time of the year, many people, especially those expecting a tax refund, are rushing to get their income tax returns completed and filed. Similarly, individuals concerned about owing taxes may want to complete their taxes as early as possible so that they can figure out how they will pay their taxes.
No matter what group you fall into, this is a good time to consider your tax situation and determine whether you need to adjust how much your employer is taking out of each paycheck. This is especially important with the new tax reform law which lowers tax rates for taxpayers and includes many changes that may impact withholding allowances. You may be able to better manage your short and long-term finances by changing your exemptions.
Why Adjust Your Withholding?
Your employer’s payroll department automatically withholds federal, state, and local taxes from your paychecks and sends them directly to tax authorities. This service means that you don’t have to calculate your tax liability nor do you have to send payments to the IRS. An additional advantage is that letting a payroll department calculate your withholding can help prevent tax liability due to financial mismanagement or miscalculations.
Your payroll department uses the information you supply on your W-4 to determine the amount of your withholding. If the information is inaccurate, you may find that the payroll department is taking out too much money from each paycheck. If you have a tight budget, this withholding will force you to save. However, you aren’t earning any interest on those funds the way you would if you put them into an interest-bearing account.
The flipside is that your payroll department may be withholding too little, which results in an unpleasant surprise around tax time. If you don’t have savings that can cover a high tax bill, you may be forced to deal with the IRS or your state revenue department to work out a payment plan. By making appropriate adjustments to your withholding, you can help ensure that you aren’t paying too much, or too little, in taxes throughout the year.
Tips for Making Adjustments
Start early in the year: The earlier you adjust your withholding, the greater the benefits. Check your current exemptions and begin crunching some numbers to determine whether an adjustment is a good idea.
Identify changes in your circumstances: If you’ve been in the same workplace for a while, your personal situation has likely changed over the years. Has your marital status changed? Do you have any children? Ideally, your HR department asked you to change your W-4 if you applied for or changed your spouse or dependent benefits information, but it’s a good idea to check that the change was actually made.
Another factor that could change your withholding needs is a side job, such as freelance or contract work. If you’re picking up the occasional side gig or driving for Uber, your earnings might move you into a higher tax bracket. Also, since you are a contractor, not an employee, your client or rideshare company isn’t deducting taxes from your payments. To avoid under-withholding, you’ll need to adjust withholding and expect to pay quarterly estimated taxes if you think you will owe $1,000 or more for the year.
Consider your needs: You know your financial needs and habits better than anyone else. If you are routinely getting large refunds and you’d rather invest that money, it’s time to adjust your withholding. Similarly, if your budget is too tight for comfort, and you historically receive a large refund, making changes to your withholding can give you the extra funds that you need throughout the year.
If you are still working on money management and typically rely on getting your “tax return windfall” every year as vacation money or for making a large purchase, an adjustment may not be right for you. But, be aware that the money you are overpaying could be earning you income in the form of investments.
Check your calculations: The easiest way to determine whether you need to make a W-4 adjustment is by using the IRS withholding calculator. It’s free to use and asks questions to help determine if an adjustment is a good idea. If you are working on your 2017 taxes, you can connect live via one-way video to a TurboTax Live CPA or Enrolled Agent to get your tax questions answered and ask questions about filling out your W-4.
Prepare to make a payment: If your calculations were slightly off and you end up owing the IRS, do your taxes as soon as possible so that you can save up what you need by April 17th. Of course, if you do realize that your withholding was inadequate, contact HR right away and revise your W-4.
Biting the bullet and taking the time to optimize your withholding allowances and monitor the impact that your tax payments have on your personal finances can make a big difference to your financial health over the long term.
Do you rely on tax withholding as a form of savings? Or do you prefer to minimize the amount you have withheld each month and use those funds for other purposes?