Establishing proper tax withholding is both an art and a science.
If you withhold too much, you'll end up paying too much throughout the year and the government will give you an interest-free loan. Too little means you're stuck paying taxes. The average tax refund this year was more than $3,000 as of March, an increase of 4.8% from last year, according to IRS data.
Whether it's too much or too little, you can adjust your withholding now to set the right amount for next year. Here are some expert tips on how to do it.
What is tax withholding?
“Withholding is an advance payment of taxes,” Eric Bronnekant, a certified public accountant and head of tax at financial services firm Betterment, tells Yahoo Finance.
Americans pay taxes when they earn or receive income. For most salaried workers, the pay-as-you-go method is when your employer deducts a percentage of your paycheck each pay period and submits it to the government.
In January, taxpayers receive a W-2, or wage and tax statement, that summarizes the salary they earned and the taxes they paid for the year. The total amount of taxes paid is not your tax bill. That's just the money you paid in advance.
On your tax return, your prepaid amount will be reconciled with your actual tax liability, and any excess amount will be refunded or you will be asked to pay the shortfall.
What are your tax withholding goals?
You can predict your annual income when determining next year's withholding tax. Forecasts should include predictable revenues such as wages, freelance work, and investment returns.
Entering this information into the IRS's Withholding Tax Estimator to generate an estimate can help you avoid unintentional overpayments or underpayments.
“Let's say a marketing consultant takes on extra work on the side and earns an extra $20,000 on top of their regular salary,” Bronnekant says. “If he did not increase his withholding, he would likely end up paying a significant amount at the time of filing.”
Once you have your income forecast, consider your withholding goals. Ask yourself, “Do I want to get my money back, break even, or go into debt?” Bronnenkant said.
Breaking even, or paying an amount upfront that roughly matches your tax liability, is a good goal to keep it simple. If you need a large enough refund, or consider it as a savings mechanism, you can increase your withholding and accumulate refunds.
For the most financial efficiency, you can hold back an amount small enough to borrow in April, but large enough to avoid the penalty. If you don't have enough money to pay the government, you can put that money in a high-yield savings account, earn interest throughout the year, and then withdraw it to pay your taxes.
“I have no problem with borrowing money,” Bronnenkant said, stressing the importance of avoiding penalties if you don't have enough tax withheld.
No penalty applies to taxpayers with less than $1,000, and most salaried workers are subject to W-4 withholding. However, if you receive unexpected income such as a bonus, you should consider increasing your withholding.
To avoid penalties, you can apply one of two IRS conditions (known as safe harbors). This means paying 90% of the taxes owed in the current year or 100% of the taxes owed in the previous year. Payment must be made in four installments: April 15th, June 15th, September 15th, and January 15th.
For example, if you owed $5,000 in taxes last year and $7,000 this year, you can exercise the safe harbor rule and pay the IRS $5,000, which is 100% of last year's debt, or 90% of your current debt. You can avoid the penalty by paying the equivalent of $6,300. annual responsibility. Using last year's debt, each quarter he would pay $1,250 four times.
The IRS has higher requirements for taxpayers with income over $150,000. To apply the safe harbor rules, you must submit 90% of the taxes owed this year or 110% of the taxes owed last year.
The IRS currently charges 8% interest on unpaid fines, up from 3% two years ago. Interest is compounded daily and begins on the tax payment date.
How to update Form W-4
Taxpayers should check their withholdings at least once a year to avoid surprises at tax time.
“My firm typically sees one client each week who either doesn't have their New York City taxes withheld or has them withheld in the wrong state,” says Kathryn Keene, enrolled agent and fellow of the National Association of Tax Practices. he says. Insufficient or incorrect withholding can result in unexpected tax bills at filing time, which is a burden for most taxpayers.
“In the old days, people would take their checks to the bank and stand in line to read their stubs. With direct deposit, no one sees their stubs,” Keene added.
You can change your tax withholding at any time by requesting and updating a copy of Form W-4 (Employee Withholding Certification) from your company's human resources department.
The W-4 form takes into account your filing status, potential credit, and estimated income to calculate your advance amount. You can increase or decrease withholding on your W-4 to account for changes in income from freelance work or investment sales.
“Let's say you decide it's a good idea to put some extra money aside for your side hustle. Then you can increase the withholding on your paycheck. You can say, 'I want an extra $50 every pay period.' ” said Bronnenkant. he held. ”
Rebecca Chen is a reporter for Yahoo Finance and previously worked as an investment tax certified public accountant (CPA).
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