The tax mistake that could hurt you now or next year

Presumably, it has been a little more than a month since you submitted your tax return for 2014. Did you end up owing the IRS or did you get a refund? There are plenty of personal finance articles that discuss the pros and cons for each of these situations. So we will skip those discussions and go right to the point: Are you happy with your result?

If not, you can easily fix it for next year by adjusting your withholding now. But it's a simple step many people forget to take.

Now or Next Year?

For example, if you got a refund this year but would rather have more money each month to help your cash flow, adjusting your withholding now could fix that. On the other hand, if you wait or forget, you lose the benefit of better cash flow for the rest of the year.

If instead you ended up owing a lot this year and you don't want to experience that again (or run the risk of incurring a penalty), this is the time to adjust your withholding to prevent that. Here again, waiting to make this simple change could leave you in the position of scraping together enough money to pay your tax liability next year.

How Do You Adjust Your Withholding?

Overly simplified answer: If you are a W-2 employee, you would fill out a W-4 form (also called “Employee's Withholding Allowance Certificate”) and submit it to your employer. This form, along with your basic information, has two important pieces of information that guide the employer on how much they have to withhold from your paycheck to send to the IRS:

  1. The number of allowances you want to claim (the higher the number, the lower the taxes withheld)
  2. Additional dollar amount you want to withhold.

Think About the Future.

It is a single form, but you need to do some work before you complete it. There are some questions in the form that will guide you to the right withholding, but you need to think beyond the obvious questions on the form.

For example, the form asks for number of dependents. Will that change in the coming year? Even if you have a baby on December 31, you can claim him/her as a dependent for the whole year.

Are you planning to get married later this year? You can go ahead and fill out the form as “married” to reduce the withholding.

Explore the Form in its Entirety.

It helps to walk through different scenarios and future events you think could happen later in the year to figure out the closest withholding amount. You might never have claimed any itemized deductions before; but if you are in the market for a house in an area with a high cost of living, you might want to try filling out the “Deductions and Adjustments Worksheet” on page 2 of the W-4 form. This form includes the usual deductions found in Schedule A of Form 1040. Every $4,000 of deductions equals one extra allowance in the W-4 form.

If you are in a two-income household, there is a little more work to be done. Fill out the “Two-Earners/Multiple Jobs Worksheet” on page 2 of the W-4 form.

Prefer to Do This Online?

If you don't want to work on a paper form and would prefer an online calculator, check out the IRS withholding calculator. It will ask similar questions to the form and spit out the number you should write down in your W-4 form to submit to your human resources department.

What if You Are Self-Employed?

If you are a self-employed taxpayer, you have a lot more power on how much you pay quarterly. You can start by dividing the amount you owed the previous year by four and send that amount to the IRS for the first quarter. As you know more about your income for the current year, you can increase or decrease the amount you send in for each of the following quarters.

Another way to handle withholding your own taxes is, if your spouse is a W-2 employee, you can adjust his/her withholding (withhold more than necessary to cover your portion of the taxes). The plus side of this method is that you don't have to worry about sending in quarterly payments, but the down side is that you can't be very flexible based on how your income fluctuates during the year because you have to fill out a new W-4 each time you want to change your withholding.

If You Fill Out a W-4, Are You Assured Our Withholding Will be as Close as Possible to What You Will Actually Owe Next Year?

No, not exactly. Here are some other factors that contribute to how much you owe in taxes:

  • Did you have income other than your W-2?
  • Did you get a lot of dividends?
  • Did you sell (or are you planning to sell) any stock?
  • Did you end up unemployed for any period of time during the year?

All of these situations will affect the amount of tax you ultimately owe. If you end up earning a lot more than what you originally anticipated when you filled out the W-4 form, you are likely to owe the IRS — and vice versa (if you end up earning a lot less, you may get a refund). It is OK to owe a little. The important thing is to avoid a penalty.

How Can You Avoid a Penalty?

According to the law, there is no penalty if:

  • You owe less than $1,000 in tax after subtracting the withholding and estimated tax payments, or
  • You paid at least 90 percent of the tax for the current year, or
  • You paid at least 100 percent of the tax shown on the return for the prior year.

When Can You Adjust Your Withholding?

You can adjust your withholding any time of the year. Of course, if you make changes later in the year, it will have less of an impact on that year's taxes. Also, any time your life situation changes — you get married, buy a house, add a new dependent — it is a good idea to review your withholding amount and decide whether you should adjust it.

Whether you want to be on the forced-savings side or the not-giving-the-IRS-a-free-loan side with your tax return, the key step is to adjust your withholding now — and hopefully now you have all the information you need to make your choice a reality.

Have you changed your withholding to free up cash flow or avoid getting a penalty? How often do you adjust your withholding?

More about...Taxes, Budgeting

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zoranian
zoranian
5 years ago

If you have a regular income, another way to try it out is to look at your current tax payment (if you have regular income) and your tax owed for the previous year. If it is much more (or less) than the tax owed when you multiply through by your number of pay periods, then you may want to make an adjustment. If you do a late year adjustment and increase or decrease by a larger amount to make up for not having much of the year left, make sure you change your withholding back on January 1st of the… Read more »

Anne
Anne
5 years ago

Does anyone know of a way that I can just specify a straight percentage to be deducted for federal taxes? I have several part time jobs. Each paycheck is fairly small so almost no federal taxes are taken out even though I claim single zero. Additionally, the paychecks are not always for the same amount. As an added complication, I am married and part of a two income household. The marginal federal tax rate that I end up owing on each of my paychecks is 30%. It is not practical to add an extra amount to take out since the… Read more »

lmoot
lmoot
5 years ago
Reply to  Anne

I’m no expert at taxes, but I’ve always had several jobs and I claim 0 on the lesser paying ones, guesstimate what the total is for all income, and only adjust the W-4 on 1 of the jobs, typically the most substantial of the jobs.

Ray
Ray
5 years ago
Reply to  Anne

It might be best for you just to pay estimated taxes quarterly.

Jane
Jane
5 years ago
Reply to  Ray

Ray if you are getting a paycheck from a job, THEY deduct the taxes, FICA, etc. If you work for yourself, then you would pay estimated taxes. But there is no way to pay a flat percentage which you as the person having to pay it will choose. There are formulas which have to be followed when an employee processes a paycheck for an employee. As for Imoot claiming 0 deductions. That will result in the maximum deductions from the paycheck. That is an indication that the employee will be declaring the fewest deductions on their tax return. Which means… Read more »

Kelly
Kelly
5 years ago
Reply to  Anne

It might be easiest to have your spouse’s withholding adjusted and keep yours the same.

Marie
Marie
5 years ago
Reply to  Anne

I am in the same boat. My partner is already adjusted to pay maximum taxes, so he can’t help me, and we ended up owing almost two grand this year. I have fiddled for several years and found no solution.

JoeM
JoeM
5 years ago

I’m a huge fan of the tax withholding calculator, as I try and make sure I have no refund or liability. This past year, I kind of mixed things up having two jobs at once and switching jobs, so I ended up with a $376 refund from federal and owing $300 to state. For 2015, I should be all set.

Jeanbe
Jeanbe
5 years ago
Reply to  JoeM

I try to get my Federal payment within $100 either side. I owe or don’t. My state taxes (AZ)I usually get about $50 back. I do tend to change my withholding throughout the year, but as my interest on my mortgage is getting more to principal it is getting harder.

Quinn
Quinn
5 years ago

Great detail, covers all of the notes for completing the Form W-4. Definitely go with the IRS calculator, saves time and asks you the different questions mentioned in this article.

Also, please note that you can update the form whenever you want, but your employer has 30 days to get the request in their payroll system. Don’t count on it occurring with your next paycheck.

Dianecy
Dianecy
5 years ago

I used to have a commission-based job. We were paid 1/2 of our base twice monthly and commissions once a month, so the comm. check would get taxed at an artificially high rate. The first year, I claimed 10 deductions (I was single then and no kids) and I still got 10% of my gross income back at tax time. Ugh. HR was no help in trying to figure it out. In fact, they told me I was making myself a “target” of the IRS by claiming 10. Double ugh. Luckily, my smart CPA told me that I could simply… Read more »

Kelly
Kelly
5 years ago
Reply to  Dianecy

Dianecy – would claiming 10 dependents DECREASE the amount withheld?

Dianecy
Dianecy
5 years ago
Reply to  Kelly

Kelly – I’m going to assume this is a real question. Each dependent you claim decreases the amount of taxes withheld. Ten seems to be a threshold i.e. more than ten makes little difference. Jane – “There are formulas which have to be followed when an employee processes a paycheck for an employee.” This is correct only up to a point. The employee has more comtrol than they might believe, which is the reason I wrote the comment above. There is a good degree of flexibility, but you must know the rules to get as close to zero owed/due as… Read more »

B'om
B'om
5 years ago

I always aim to owe the IRS a small amount. That way if my social security number is involved in a fraudulent return, I am not left waiting for my refund while the IRS sorts it out.

Norman Financial
Norman Financial
5 years ago

Really great informative article. Taxes can get crazy complicated for people. Thanks for sharing your knowledge

getagrip
getagrip
5 years ago

I’m on the other end in that with kids graduating college and moving off on their own I’m paying more in taxes because I’m losing them as a deduction. So I have been reducing the number on my W4 to ease the end of year pain a bit.

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