In accordance with the U.S. tax system, most individuals take the pay-as-you-earn (PAYE) approach, in which estimated income tax is paid throughout the year and then accounted for on tax day of the following year. Employers are legally required by the federal government to withhold part of their employees' income for taxes by deducting a portion of their regular salary from their paychecks.
To calculate the precise amount they withhold, employers rely on the information all new employees provide on Form W-4. If too much tax is withheld, employees receive refunds.
However, a lot can change over the course of a year. In certain circ*mstances, it makes sense to revise the amount of income that gets withheld.
Key Takeaways
- The United States' pay-as-you-earn tax system encourages taxpayers to withhold income from their paychecks for federal income tax.
- Your marital status (and changes to it) has a material impact on taxes that you owe.
- As your family expands and more dependents are added, you may be eligible for additional deductions and tax credits, meaning lower taxes and less income withheld.
- Major life purchases such as your first home result in tax benefits that reduce the amount of taxes owed.
- You can change how much to withhold by submitting a revised Form W-4 to your employer.
Events That Trigger Changes
The amount of income withheld for taxes is governed by the following considerations:
- Whether you select a "married" or "single" rate on your W-4
- The amount of income you earn (from a single or multiple jobs)
- Whether you wish to withhold extra funds
- The number of allowances you qualify for
Changes in your household situation, such as the birth of a child or a spouse losing a job, can immediately impact the taxes you'll owe. In these situations, it is well worth changing the amount of withholding to avoid paying more taxes than necessary.
Marriage
If you are married and filing a joint tax return, your taxes may be impacted in one of two ways. First, if your spouse earns an income, your overall household withholding may need to increase. Second, if your spouse doesn't work, your overall withholding will likely decline. There are also situations in which separate filing makes sense.
Divorce
Divorce can alter your household income, but there is also the matter of alimony. Alimony began receiving a different tax treatment starting in 2019, thanks to the 2017 Tax Cuts and Jobs Act. Alimony payments are no longer tax deductible for the payer and alimony recipients do not have to declare alimony as income.
Birth or Adoption
The birth or adoption of a child immediately adds a dependent to your household and lessens the overall tax burden (to compensate for the costs of raising children). To capitalize most quickly on the credits and increased deduction, consider reducing your withholding.
When your children grow up and if they move out, consider readjusting your withholding as you may no longer be eligible to claim them as a dependent.
New Home (or Other Major Purchases)
When purchasing a home, you can update your withholding in anticipation of tax benefits. There are a number of credits for first-time homebuyers, and the list of tax benefits approved by the IRS regularly changes.
This holds true with any large deduction or credit you may become eligible for within a given year, including education credits, dependent care expenses, medical expenses, and charitable donations.
Big Increases in Non-Wage Income
You must adjust your withholding to account for any non-wage income from side businesses, stock dividends, or interest income. For example, if you successfully invested and sold stock or cryptocurrency for a profit, the proceeds are subject to short-term or long-term capital gains, depending on your holding period.
Working Two Jobs
Two-income households and individuals who work multiple jobs are vulnerable to withholding disparities. This is especially true if a withholding form is completed for each job. For example, working two jobs where each pays $25,000 could push a taxpayer into a higher tax bracket (compared to working just one of those $25,000 jobs). However, independently, each withholding form may indicate that the taxpayer earns only $25,000 and falls within a lower tax bracket.
Similarly, losing a second job and its associated income allows you to reduce the withholding for your remaining job. You might also claim allowances that you previously held off on.
Getting Your Withholding Right
The IRS features a useful withholding calculator on its website. In addition, Form W-4 contains useful instructions that can help you estimate your withholding correctly.
Here's an overview of the steps to take to adjust how much income is withheld for taxes.
1. Use the IRS online Tax Withholding Estimator to estimate your federal income taxes.
2. If you determine that the change in your taxes is large enough, contact your employer to revise your federal income tax withholding. Your employer may give you a blank W-4 form to complete or may direct you to an electronic platform to submit the information.
3. If you have multiple jobs or if both you and your spouse work, complete Step 2 of Form W-4. The information from this step is used in the steps below.
4. If you have dependents, complete Step 3. This step determines what portion of your income is reduced due to the dependents you are claiming.
5. If you receive other income (not from jobs), such as interest, dividends, or retirement income, enter the amount in Step 4(a).
6. If you anticipate that you'll claim a deduction(s) other than the standard deduction, enter the amount you expect to claim in Step 4(b). You can use the Deductions Worksheet attached to Form W-4 to figure the amount. As an example, taxpayers who buy their first home are eligible for additional tax deductions.
7. If you expect that you'll need to pay more taxes, you can opt to withhold an extra amount by entering that figure in Step 4(c).
8. Upon submitting a revised form to your company, ensure that the appropriate changes have been made by comparing your previous and current pay statements. Changes to your withholding amount may be delayed by one or two pay cycles.
While you cannot claim the same allowances as your spouse, you can split them up.
Is It Better to Withhold More or Less Taxes?
If you want to avoid paying taxes when you file your tax return, it is better to withhold more income throughout the year. However, there is a lost opportunity when withholding more than necessary. By overpaying taxes in advance of when they are due, you lose the chance to invest those funds and potentially grow your capital.
Will Changing Withholding Affect My Paycheck?
Yes, changing your tax withholding will change your take-home pay amount, though your gross pay will not change. Increasing your tax withholding reduces your net paycheck amount, while decreasing your withholding increases it.
How Do I Update My Withholding Amount?
If your employer withholds taxes on your behalf, you can submit a revised Employee's Withholding Certificate (Form W-4).
The Bottom Line
People may go years without the need to significantly alter their withholding status. However, when life changes do occur, it's worth taking the time to re-file a W-4 with an adjusted withholding amount. If you pay the government too much throughout the year, you will will receive a refund for the overage. But you'll have gone without that money (and have made the government an interest-free loan). If you pay out too little, you may be surprised by a large bill.
