Here’s the next in a series of monthly posts focusing on meeting small, manageable financial objectives in order to create a path to overall financial success. You can find August’s post here.
Have you ever had a surprise at tax time? Maybe you owed a lot more than you expected to, or got a much bigger refund than you anticipated (and that last one sounds nice, but it’s really not all that great - more on that later).
If you’re a regular salaried employee, you completed a W-4 form when you were hired. That form instructs employers to withhold a certain amount of tax from your pay. The amount depends on how you answered questions like whether you are married, whether you only have one job, if your spouse also works, and how many dependents you have. These are the personal allowances you claim - the more you claim, the less tax is withheld, and the fewer you claim, the more tax is withheld. You can even claim zero allowances to have the maximum amount of tax withheld.
Important: this number isn’t necessarily the same as the number of exemptions and dependents you claim when you file your tax return - that number is based on specific rules about whom you can claim as a dependent and what filing status you use. This number is just a way to manipulate the withholding to achieve a particular result. The two numbers don’t have to match.
If you’re self-employed, you pay estimated taxes quarterly based on your income, at a rate similarly decided early in the tax year.
One of the problems here is that it’s hard to predict what will happen throughout the year. Maybe you got a big unexpected bonus. Maybe you were out of work for a couple of months. Maybe your spouse had a big career change. Maybe the baby turned out to be twins. The point is, we’re at a good spot in the year to assess your situation and figure out if the year will end more or less as you expected it to, income tax-wise, and if not, to make some adjustments. So gather your most recent paystubs for all jobs worked this year (and income, expense and quarterly estimated tax information if you’re self-employed) and maybe last year’s tax return too and check out the IRS’ withholding calculator: https://www.irs.gov/individuals/irs-withholding-calculator
The calculator will tell you how to adjust now so that you end the year having paid very close to the correct amount of tax, IF you provide the correct inputs. Use last year’s return as a guide for credits and deductions. Remember to include all of your income for this year, including jobs you left, to make sure you get the most accurate picture. If there’s a change to be made, you’re still in time to do it, or at least be aware of what awaits you when you file a return.
If you have been significantly underpaying, you might have just saved yourself a penalty. The IRS prefers that you pay your taxes all along, and imposes this penalty if you do not pay at least 90% of your tax for the current year or 100% of the prior’s year’s taxes, whichever is smaller.
On the other hand, if it turns out that you’ve been overpaying, it might not feel all that urgent to change anything, and in fact you might be looking forward to filing and getting the money back. But in general, it’s better to have the money all along. It is yours, after all, and you’re not earning anything on it. If you have debt, you could have been paying it down throughout the year, saving significant interest expenses. And if you can invest that money, that’s potentially a year’s worth of compounding you’re missing out on. So go conservative if you want, but don’t overpay by too much!