Form W-4 is an IRS form, Employee’s Withholding Certificate, that employers use to calculate payroll taxes and send the taxes to the IRS and certain states on behalf of their employees.
If you are an employee of a company and filled out Form W-4 at the start of your employment, then you are having taxes withheld from your pay as a result. But no one really gives you a step by step guide as to what the numbers really mean on the form and how the form will ultimately impact you and your tax bill.
So my goal in writing this post is to educate you a bit on withholding, identify how you are impacted as a result of the way you fill out your Form W-4 and go through some of the pros and cons of withholding too much or too little.
Employers use this form along with the tax withholding tables provided by the IRS to determine how much income tax to withhold from your paycheck.
The W-4 form considers the number of dependents you have in your household, your filing status, the income you generate and whether you’re claiming the standard or itemized deductions on your tax return.
The W-4 changed in 2020 and did away with claiming personal exemptions to reduce your tax withholding. The IRS revamped the form a bit and now in order to reduce your tax withholding you are required to claim dependents or utilize the corresponding deductions worksheet that comes with the form.
So here’s a little breakdown:
If you claim all your dependents and deductions on Form W-4, then less withholding taxes will be taken out of your pay. You will then take home more money with each paycheck. But come tax time and when you file your tax return, if you withheld too little, you run the risk of having a tax bill.
Tax due is a result of paying too little taxes through your withholding or otherwise throughout the year.
If you opt to claim Single with no dependents or deductions, despite your marriage status and dependents, you will have significantly more withholding taxes taken out of your pay. You will then take home less money with each paycheck. Come tax time, if you withheld too much, you’ve given the IRS more money than required and will result in a tax refund.
Tax refunds are a return of the money you overpaid in taxes during the prior year.
Your tax liability will be the SAME despite how you choose to withhold your taxes. It is just a matter of WHEN you pay the tax. Throughout the year in your withholding, when your tax return is due, or a combination of both. It is the SAME tax liability dependent on your income, filing status, deductions, credits, etc. (excluding penalties).
Getting a large tax refund is the result of withholding too much throughout the year. People refer to this as an interest free loan to the IRS – you’ve given the IRS more than required instead of keeping that money for yourself throughout the year.
You withheld too much throughout the year meaning that money that could have been in your pocket each and every paycheck instead of going to the IRS. You could have been taking that extra money each month and investing it or paying down debt to better position you for financial success.
So if you are one of those individuals who receives a significant tax refund and says you will invest your refund or pay off your debts that have accumulated when you receive it come tax time, then yes my suggestion would be to consider the following:
HOWEVER, if you do not plan to invest or payoff debt with that tax refund and you are maxing out your retirement plans or contributing as much as you feel comfortable with throughout the year and have no debt – then withholding more and receiving a significant tax refund could be a great alternative savings account.
Here’s the thing – I understand the consequences around withholding more and having less for myself each paycheck. But let’s not forget, personal finance is personal. I enjoy getting a large refund for three reasons:
So sure, I could have been getting more money each paycheck and transferring that to a savings account. Ok, I missed out on $50 of interest from the bank. But you know what else I missed out on, the opportunity to take it out to spend on something else that wasn’t part of my short term goals or needs. The money wasn’t there and deposited into my account, I was not tempted to spend it elsewhere.
That is how I have created a discipline for short term savings – through the automation of my withholding.
Examples of short term goals could be – home improvements or renovations, travel and vacation plans, replenishing your peace of mind account or using it as a means to budget out the next 6-12 months.
So long as short term savings rates are at laughably low numbers, I will continue to plan to use my refund for short term savings goals.
There are a few times in your life that you may want to consider revisiting your withholding as a result of a life changing event that will have an impact on your taxes.
Hope you found this helpful in identifying why you may opt to choose one option vs another and to determine what works best for you and/or your family.
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