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How Tax Withholding Works

In 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 [3] 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 [4]. There are, however, risks involved in adjusting your withholding [5] too aggressively.

This post is part of Bargaineering’s 2010 New Graduate Guide [6] 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 [7]. 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 [8] 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 [9])