The Ultimate Guide to Setting Withholdings

Many taxpayers look forward to tax season because of tax returns. While getting a large sum of money all at once is exciting, it also means that you overpaid your taxes.

On the other hand, getting a nice check from the government feels way better than owing taxes. If you owe too much, you could be fined or need to seek tax relief.

The big question: What determines the size of your tax return?

The answer: Tax withholdings.

Understanding tax withholdings and setting them carefully will help ensure that you’re not overpaying or underpaying.

This article will answer the following questions people have about tax withholdings:

  • What is tax withholding?
    • What is federal tax withholding?
      • What is Medicare tax withholding?
      • What is Social Security tax withholding?
    • What is state tax withholding?
  • How do you calculate taxes from your paycheck?
  • Should I change my withholding?
  • How do I change my withholding?

What is tax withholding?

Employers generally take payroll or income taxes out of their employees’ pay before giving employees their paycheck. If you want to know how much you’re paying in taxes, you can take a look at your pay stub and W4s.

If you’re self-employed or a contract worker, you’re responsible for paying your own taxes.

What is federal tax withholding?

The federal tax withholding is determined based on how much you make. These percentages are consistent across the U.S. but are subject to change. The IRS publishes withholding charts for every tax year that detail what people with different W-4 allowances, tax filing statuses, and income levels will owe in taxes. This information is especially useful for employers and self-employed individuals.

The federal tax withholding also includes Medicare and Social Security taxes.

What is Medicare tax withholding?

Unlike the payroll and income tax rates, the Medicare tax percentage rates do not vary based on the amount earned. The tax rate is 1.45 percent for people earning up to $200,000 annually. If you make more, an additional .9 percent tax is applied. Employers also pay a 1.45 percent Medicare tax.

Medicare taxes go to fund Medicare — medical, hospital, and prescription drug insurance for Americans over age 65.

What is Social Security tax withholding?

Social Security taxes are also consistent across the United States and income levels. It is 6.2 percent for individuals. Employers also pay 6.2 percent in Social Security taxes These funds are dispersed to qualified American retirees, individuals receiving disability, and to surviving minors and spouses of deceased workers.

What is state tax withholding?

Each state has its own tax laws, so the state tax withholding varies state to state. Some states do not tax income. You can find information about your state’s taxes and tax withholdings online.

The department that manages state taxes has a different name in each state. For example, the New York State Department of Taxation and Finance manages taxes in New York, and the Missouri Department of Revenue manages taxes in Missouri. Once you know the department name in your state, you can find good information about state tax withholdings from the official webpage.

Depending on your community’s local laws, you may also have to pay additional taxes.

How do you calculate taxes from your paycheck?

Tax withholdings vary based on how much you make. If your employer takes taxes out of your paycheck, the easiest way to see how much you’re paying in taxes is to look at your pay stubs. For the annual amounts, multiply the tax deductions by the number of pay periods in a year.

“You want to make sure you have the right amount of tax withheld to set yourself up for a successful tax season. If you withhold too little, you might find yourself owing money in taxes next April. If you withhold too much, you might get a big refund but you’ll likely be short on cash all year,” says Joshua Zimmelman, President of Westwood Tax and Consulting, LLC.

If you’d like to do the math yourself to make sure that your withholding is correct, here’s the breakdown:

  • Know how much you make annually.
    Your annual earnings affect what tax bracket you fall under, which determines the amount you pay in taxes. If you don’t know that number specifically, it’s important to make a good estimate to make sure that you’re paying the right amount of taxes.
  • Look at the tax withholding charts.
    The IRS publishes the amount each earning bracket will need to pay in taxes annually. The charts are broken down by filing status and number of dependents.

Alternatively, you can use the IRS withholding calculator to make sure your withholdings are correct.

“The IRS website has a withholding calculator to help you make sure you’ve got the correct amount of tax withheld from your paychecks. You’ll want to have last year’s tax return and your recent pay stubs handy.” says Zimmelman.

How often should I check my withholding?

Fully understanding your finances includes understanding what you’re paying in taxes.

“It never hurts to see if your withholdings are on track. A big refund means you’ve over-withheld, effectively giving the government an interest free loan. Owing money could mean you face added costs in penalties and interest. If you check your withholding throughout the year, you can take control of the situation and your money,” says Ann Brookes, LL.M. in taxation and tax attorney.

While taking the time to check your withholding can sometimes be tricky to prioritize and work into a busy schedule, in some situations it’s an especially good idea to double check.

Brookes says, “I encourage taxpayers to check their withholding when there is a job change, extra income such as a lottery win, or rental income on a cottage, sale of stock, or distribution from an IRA. Withholding on your main paycheck doesn’t account for extra income, and it’s important to consider the big picture.

Taxpayers who file jointly and have both self-employment income and W-2 income might consider increasing withholding on the paycheck to alleviate or eliminate the estimated tax payment amounts on the self-employment side.

In all cases, I encourage taxpayers to do a withholding check in the fall. If it turns out they have over-withheld, they have the chance to reduce or eliminate withholding for the remainder of the year. This means a bigger paycheck at the holidays. Just remember to switch it back in January.”

Should I change my withholding?

Before you decide to change your withholding, think about whether or not you need to.

“If you’ve experienced a major life change (marriage, divorce, new child, new home, new job, or anything else that could affect your tax liability) you should examine your withholding and see if it needs to be adjusted. If you haven’t already adjusted your withholding after the new changes under the Tax Act then you should definitely get informed about how the tax act changes your taxes,” advises Zimmelman.

In some cases, adjusting your withholding may be strategic.

“If you often get a large refund, considering adjusting your withholding to give you more money per paycheck. But don’t spend that extra cash, put it in an account where it can earn interest. You might not end up with a big refund at the end of the year, but you’ll have grown your savings. Worst case scenario, you can use some of those extra savings to pay an unexpected tax bill if your calculations were slightly off.” Zimmelman says.

With the effects of the Tax Cuts and Jobs Act, it’s worth taking a second look at your withholdings.

“A lot of taxpayers were surprised by a smaller refund or an unexpected tax bill this year. This doesn’t mean their taxes went up; it just means that they saw the benefits of the Tax Act during the year, through larger monthly paychecks. The tax withholding tables were adjusted under the new tax act, but not everyone adjusted their withholding appropriately. Many people weren’t withholding enough during the year so they were left coming out short once tax season came,” says Zimmelman.

How do I change my withholding?

If you want to change your withholding, you need to submit a new W-4 to your employer. If you’re making adjustments to state and federal tax withholdings, you may need to submit a state W-4 and a federal W-4.

The federal W-4 takes information about yourself, the allowances you claim, and your employer. The form also includes worksheets to help you determine the number of allowances and kinds of adjustments you should make.

Some states use the federal form to determine state income withholdings. Other states have their own forms. Your employer should be able to give you information on what forms they need to adjust your state withholdings. If you’d like to see what forms are necessary in your state, here’s a helpful guide.

Be careful when adjusting your withholdings: you don’t want to underpay your taxes and receive penalties.

“The simplest rule of thumb is using the IRS’ ‘safe harbor’ rule to avoid any underpayment penalties. You won’t owe any penalty if either of the following applies:

  • You owe less than $1,000
  • If you pay 100% of your previous year’s tax liability through regular withholding or estimated taxes. (110% if your Adjusted Gross Income, “AGI”, is over $150,000)
    (Your 2018 AGI can be found on line 7 of your 2018 Form 1040.)” advises Ben Watson, CPA and Virtual CFO of DollarSprout.

Setting your tax withholdings well will ensure that you don’t overpay or underpay your taxes. It will help ensure that you have access to all of your money throughout the year and don’t owe the government any taxes when you file.

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