Tax withholding is often seen as a mysterious science where it is better to err on the side of caution and not "to tamper with laws of nature that man was never meant to know!" Sensationalism aside, paying attention to and adjusting your tax withholding via the form W-4 is an important way to ensure you are not under or over withholding for taxes. (Understanding the origins of our tax withholding system is crucial to getting the most out of it. Refer to Understanding The U.S. Tax Withholding System.)
TUTORIAL: Personal Income Tax Guide
Another Tax Form?!
The chances are that you know the W-4 even if you don't remember it. It is the basic form you file every time you start a new job. Because the United States tax system is pay-as-you-go, there are really only two choices: withholding or estimated tax. Estimated tax payments are used by business owners and some regular people with large amounts of dividends, royalties or other significant income streams beyond their 9-to-5 job. We'll look at the plain vanilla withholding in this article.
Events That Trigger Changes
Your withholding is made up of three basic pieces of information:
- Whether you are using a married or single rate
- What allowances you qualify for
- Whether or not you want to withhold extra
Changes in your household situation - one spouse loses a job, a child is born and so on - can have an immediate impact on your tax situation. In these situations, it is well worth changing withholding to avoid owing a big tax bill or essentially loaning the government extra money at zero interest. The first life event is probably the most obvious.
Will You Marry Me?
Don't say yes just because you love filing updated W-4s, but do keep in mind that marriage will affect your taxes in one of two ways. One, if your spouse has an income coming in, your overall household withholding may go up. Two, if your spouse doesn't work your overall withholding will likely go down. Of course, marriage isn't always a permanent arrangement. (Not sure whether you should file jointly or separately? Check out Happily Married? File Taxes Separately to learn about situations where the separate filing makes sense.)
You Ruined My Life and My W-4!
A divorce can change your tax situation in a couple of key ways. It will, of course, alter your household income, but there is also the matter of alimony. If you are paying alimony, you can adjust your withholding to reflect that by filing a new form. If you are receiving alimony, you have to pay the tax on it and will have to file a new form as well. (To learn more about taxes following a divorce, check out The Fundamentals Of Spousal Support Taxation.)
Junior Means a Tax Break
Having a baby, while perhaps not all fun and games, does mean new allowances that should reduce your withholding. Adopting or giving birth to a child immediately adds a dependent to your household and lessens the overall tax burden to compensate for the expenses that come with raising children. Of course, this also means that when your children grow up and move out, you have to adjust your withholding back up.
The New Digs or New Deductions
When you purchase a home, you will need to update your withholding for the expected tax break. Of course, you can leave this until the end of the year, but opportunity cost shows us that money now is worth more than money further down the road. The same is true with any large deductions or credits you will become eligible for within a given year, whether education credits, dependent care expenses, charitable giving or any of the others.
Big Increases in Non-Wage Income
Any non-wage income, whether from a side-business, dividend stocks, interest income, etc, will come as a surprise to the IRS - and an unpleasant surprise for you - if you don't adjust your withholding to reflect the extra cash. Remember that the W-4 is aimed at reflecting the average American household. If you are seeing significant amounts of income from sources other than your 9-5, you will need to withhold more or begin paying estimated tax to avoid a big bill at tax time.
Working Two Jobs
According to the IRS, most withholding disparities are created by changes in employment. If you are working two jobs, you can split your allowance between them, but you cannot claim double the allowances (that is, claim the same allowances twice). Similarly, losing that second job means that you can reduce the withholding on your remaining job or claim allowances that you were previously holding off on.
Getting Your Withholding Right
The IRS provides a very good withholding calculator that can help you account for these credits, but they will not do it for you. Simply put, they don't mind paying out refunds at all, and it is not worth adding the salaries needed to make sure everyone's salary is being withheld at the proper level.
The IRS also provides worksheets for converting credits to withholding allowances and tips about common errors. For example, you cannot claim the same allowances as your spouse, but you can split them up as needed. The chances are very good that you will learn something new by reading through the relevant publications.
The Bottom Line
It may seem like there are many circumstances that will require you to adjust your withholding. In reality, most people will go years without having to significantly alter their withholding. However, if any of these changes do occur, it is well worth the time to file the W-4. Best-case scenario, you are giving too much to the government and they will return it to you without interest. Worst case, you'll owe a big chunk of change and, oddly enough, they'll be charging you interest on that until you pay it off. (It's important to understand where that money coming out of your paycheck goes and why - after all, you earned it. See Tax Withholding: Good For Government, Bad For Taxpayers.)