It’s summertime, and like me, I’m sure you know this is the perfect time of year to be thinking about your taxes. (Ok, seriously), I know you’re NOT thinking that, but you should be. Especially if you splurged on a summer vacation using your big, fat, tax refund. It really is important for you to understand how tax withholding works, and there’s no time like the present!
By now you’ve probably finished filing your 2020 taxes, and have paid Uncle Sam or gotten your refund. Some people love getting a big refund. Almost no one likes owing a lot to the IRS. Having the right amount in your regular paycheck allows you to meet your financial goals consistently month to month. As financial planners, we help our clients think about their tax situation throughout the year to avoid surprises come tax filing time.
One of the ways we do this is to help clients assess their year-to-date tax withholding. You may not have noticed that in 2020 the IRS rolled out a new W-4 form. This is the form that you fill out when you start a new job. It helps your employer figure out how much to withhold from your paychecks for your future tax obligation.
Taxes are often not straightforward, nor static, and your employer needs all the help you can give them to withhold the right amount. Even similar employees with similar incomes can have wildly different tax situations so no two employees are the same. If your income is variable, you may even notice that the withholding changes a percent of your paycheck every time you get paid.
In general, though, employer withholding is meant to be at the blended rate they think your taxes will be when you file at the end of the year (even though our tax system is “progressive” – meaning you pay less tax on lower amounts and a higher percent on additional amounts).
Then vs. Now
In the past, all you had to do was report how many exemptions to claim when you filled out the form. The default for many people was to claim “Single with 0” like they did in their first summer job in high school. That system wasn’t ideal, and the 2017 Tax Cuts and Jobs Act got rid of personal exemptions, so a new system was needed.
If you haven’t changed jobs since 2019, you don’t have to fill out a new form. But you can if you want to. For those of you starting a new job in the last couple of years, you probably looked at the new form and thought “Wha??”.
Here’s how it works. As a W-2 employee, you make money. (The system is different if you own a business or you’re self-employed). Your employer estimates how much taxes you’ll owe using the W-4 and your compensation, and sends the money to the IRS throughout the year.
Generally, it can produce a decent estimate. If you’re single with no dependents, one job, and no itemized deductions, you can likely leave your old form in place. The new W-4 form allows you to provide additional information that allows the estimate to be much better than it used to be.
If you have a spouse who works, you hold more than one job, you claim dependents, you itemize deductions, or you want extra money withheld, you’re better off submitting a new W-4 form even if you don’t have to.
The IRS has some good resources to help you fill out the form, and evaluate your withholding throughout the year. They provide a calculator which is my go-to when I’m helping clients out. Their FAQ page is a great reading to understand nuances that may make your situation unique.
Recalculations for Tax Withholding
Even if you are diligent about filling out the form, there can be several life changes that happen throughout the year that require a complete recalculation.
Possible Life Changes
You changed employers (or work for more than one).
- Many people underestimate how changing employers or having more than one job impacts their taxes. Once you start a new job, your new employer’s payroll system doesn’t know anything about your previous employment or other jobs. This means the taxes withheld are based on this job only. At the one end, you could have nothing withheld because you’re not making enough at this job. At the other end, you could have been over the SS max at your previous job and have to start over. Getting money withheld in your paycheck that you won’t see again until you get your refund next year.
You’re making more money (or less) than last year.
- If you’re making more this year, you may phase out of deductions or credits you claimed last year like the student loan interest deduction or child tax credit. You may also be unable to directly contribute to a Roth IRA account because you’ve reached the income limits. If you’ve already made those contributions this year in error, you’ll have to withdraw your excess contributions. On the other hand, if you’re making less, you may be eligible for additional deductions and credits, or want to plan to make additional retirement contributions or conversions.
You bought or sold real estate.
- Buying or selling real estate can affect your taxes whether it’s your primary residence or a vacation or rental property. It’s important to understand how any gains or losses may be treated, and how property taxes and mortgage interest paid may be limited under the newer 2018 tax rules. If you bought property, you may be eligible for additional deductions. You will want to understand whether it makes sense to take the standard deduction or itemize.
- Whether you moved for a job or personal reasons, you will want to understand if you’re eligible to deduct your moving expenses. You also may pay more, or less, state and local taxes than you did before, and you will want to understand how your new situation will affect how much you’ll pay in federal taxes. If you moved from a high-tax state to a low one, it may no longer make sense to itemize. If you moved to a high-tax state, you might want to itemize when you didn’t before. Other state tax deductions such as contributions to 529 accounts may be different than what you’re used to. Double check when you move.
You got married or divorced.
- The IRS treats your marital status on 12/31 of the tax year as your status for the whole year. If you get married or divorced during the year, you will want to adjust your tax withholding.
For many of our clients, and maybe you too, they have additional complexity to their income that can make their tax withholding tricky.
You receive bonus income.
- Withholding on this income is typically a flat amount: 22% for amounts under $1 million, or 37% for amounts over a million. This may be not enough or too much depending on how the rest of your taxes look.
You receive stock compensation.
- You receive vested Restricted Stock Units (RSUs), you exercise a non-qualified stock option, or you sell ESPP shares. These situations can cause you to have additional W-2 income that you hadn’t planned for. You may need to adjust your withholding. More on these situations coming up in our blog series on equity compensation, so stay tuned!
You are subject to AMT.
- This is the Alternative Minimum Tax rates. The changes in the 2017 TCJA means that many fewer people are subject to the AMT than used to be. We expect this to change when the TCJA provisions expire in 2025 (if they do).
You receive other income where taxes aren’t withheld like dividends, interest, capital gains, or other distributions.
- For many people, these amounts are not material (like that $0.05 you earn in interest on your checking account). For those who are, it’s important to adjust your withholding to account for these items.
The good news is you can do a lot during the year to make your withholding as accurate as possible. The bad news is that you may have to do it again at the beginning of next year. Changes made now are meant to make up for what happened during the first half of the year. If you adjust in January again, hopefully you won’t need any more changes next summer – unless, of course, life!
Reach out if we can help you with your questions around this topic!