How Tax Withholding Works

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TaxesIn the United States, you pay taxes on your income as you earn it. If you earn $10, you’re expected to kick the taxes to Uncle Sam every quarter in the form of quarterly estimated payments. If you earn $10 from your employer, the company has the pleasure of withholding those taxes and forwarding them to the Treasury on a regular basis. If you’re short by too much by the time tax day comes along, you’ll be hit with penalties and interest. If you’re short by just a little, then you’ll be OK.

Some personal finances experts will recommend that you adjust your withholding to minimize the amount of unnecessary withholding each month. In general, I’m in favor of that because it’s always better to keep the cash in a savings account. There are, however, risks involved in adjusting your withholding too aggressively.

This post is part of Bargaineering’s 2010 New Graduate Guide series where I’ll share my insights and offer my financial guidance to the graduate class of 2010. This post is part of day 4, tangling with the tax man.

W-4 Allowances

You can adjust your withholding by claiming allowances on a W-4 form. This form lets you take into account deductions and credits that you are eligible for and that can reduce your tax burden. The withholding system wasn’t designed for today’s complex financial situations, like two income households, and so tweaking your W-4s has become the defacto way of accounting for the changes. The form will walk you through how to adjust the withholding so you don’t have too much withheld.

Income Tax Safe Harbor Rule

The safe harbor rule governs whether or not penalties and interest will be assessed if you underpay your income taxes. You are safe if your underpayment is less than $1,000. You are also safe if you paid within 90% of your actual liability. Finally, you are also safe if you paid more in taxes than you did the previous year. Those are the three main ways you can be safe if you’ve underpaid your taxes to the federal government.

Local and state governments may handle safe harbor differently than the Federal government. In Maryland, the safe harbor rules are similar with one exception. You are safe from penalties and interest if the tax you paid this year exceeded 120% of the amount you paid in the previous year. For Federal taxes, that amount is only 100%, so it’s a slightly higher burden.

Be careful when you are adjusting your withholding because you don’t want to reduce it by too much. Any interest you earn by putting it into savings will seem foolish compared to the penalties.

(Photo: alancleaver)

{ 11 comments, please add your thoughts now! }

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11 Responses to “How Tax Withholding Works”

  1. eric says:

    Totally agree. I’ve read a lot of advice that says you should just max out the allowances without explaining the risk of underpaying your tax.

  2. Faris says:

    Recently started following your blog. Love it!

    That’s a nice post. It got me thinking and digging through IRS publications for a while. Here’s the question though. From what I understand at there are 2 ways to pay income tax for individuals (pay-as-you-go)

    1- Tax withholding by the employer: Must fill form W-4. Now, one can be “exempt” if there is no tax liability last year or this year. But if you’re exempt, you just don’t pay tax. Neither by withholding nor by estimated tax.

    2- Estimated tax: Quarterly tax payments. Wording on IRS website under information for “employees”:

    Estimated tax. ***If you do not pay your tax through withholding***, or do not pay enough tax that way, you might have to pay estimated tax. People who are in business for themselves generally will have to pay their tax this way.

    So, how do I NOT pay tax through employer withholding, and go for the estimated tax option? I want to receive my full salary and then calculate and pay my taxes myself. Like business owners. Is this possible or is W-4 mandatory? Is it illegal for my employer to let me have my full salary pre-tax and trust me to make payments to the IRS every 3 months?

    Thanks and keep up the good work.

  3. Don C says:

    I prepare a lot of tax returns for people and love when I see their faces when I (jokingly) ask them to give me the money for a year and I will give it back to them next summer to accomplish their “forced savings”.

    Don’t give the gov’t an interest free loan! What happens if you lose your job or have an unexpected emergency where you could use the extra cash? Why wait until next year to get your money? Foolish.

    Best case scenario? You owe the gov’t a little bit (under $100) each year.

    • Shirley says:

      By the same token, if you asked them right then to give you all the money that they had overpaid that year, would they have it?

      If it was not returned to them in a lump sum, how many would actually have saved (or done something constructive with) it or even know how much they were overpaying?

      • Shirley says:

        Oops… sorry
        By the same token, if you asked them right then to give you all the money that they had NOT overpaid that year, would they have it?

      • Don C says:

        As a CPA, I am in a position to determine if clients ere overpaying or not. I some cases I can tell what their next year’s refund will be in in the first few months of this year. They are still reluctant to change thier withholding even knowing they can increase their weekly / monthly take home pay by X dollars. They always say they will just sepnd on nonsense anyway. I suggest they have the extra pay automatically deposited to a separate savings account. Someone else posted that it’s psyhcological. True, but still foolish.

  4. I’m actually on the fence in terms of whether you should try to aim for reducing all unnecessary withholdings. Everyone comes back with the idea that you’re giving the government an interest free loan, but what do you think will ultimately make the most difference to you? Knowing that you won’t have to pay any taxes or come tax season getting a nice refund that you can immediately throw into a savings account. Or having to scrounge up money that I may not have set aside to pay off taxes? Personal finance is as much a game of psychology as it is one of math, if you have the discipline to save the money that would have gone to taxes and done something better than more power to you.

    Don C’s argument losing your job or having an unexpected emergency is a very good argument and it should be taken into consideration as well.

    • cubiclegeoff says:

      The interest free loan concept makes it seem worse than it is (usually). With an average refund generally under $3000, your current interest from savings would be less than $37. Is that amount (about a meal or two in many places) worth giving up for someone who is not a good saver to be able to get the refund and deposit it in savings instead of trying to do it every paycheck? I think it may be.

  5. I still just DON’T understand how to figure it out. None of these rules make any sense to me: they simply don’t compute.

    There doesn’t seem to be any realistic way for a person who’s not a math whiz to figure out how much they SHOULD be paying on this year’s income, particularly if income comes from several sources, and particularly if you have a full-time job where a bunch of things are being sucked out of your paycheck pre-tax and a bunch of other things are vacuumed out post-tax. If I could understand what I was supposed to pay–not some make-believe “marginal rate” that ISN’T the real rate, then I could see how much to withhold. But because there’s no way of calculating what you’re really going to end up paying, there’s no way to know how much you should have withheld.

    To avoid having to pay penalties, then, to my mind it seems you’re safer over-paying than trying to jigger your withholding to come out even. How much, really, would you make on the money not paid to the gummint, at a max of 2% at some online bank, compared to how much you’d have to pay in penalties if you miscalculated?

  6. I have been playing around with my deductions, but I am still at a point where I am receiving too much of a tax return every year. I will have to keep reducing the amount as I would rather get the money back in my paycheck that receive a massive check during tax time.

  7. Barbara says:

    I give alot of referals to a company, which I get paid for doing. Do I have to pay taxes on that money

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