June may seem like a time to breathe easy on tax issues, but for many workers, this is the moment to take stock and examine an overlooked portion of your taxes: your withholding. With some thought and a quick calculation, taxpayers can avert a significant headache down the road. Now is the time to examine your W-4, a form that has taken on new meaning and challenges in our rapidly changing economy.
The often-overlooked Form W-4 may be the ultimate psychological experiment, one buried deep in the tax code. The IRS asks you to decide, “Do you want a small reward now but risk both owing on April 15 and a penalty down the road? Or do you want to pay a little bit more upfront and then get a nice bonus next year?”
Here’s how it works: The W-4 tells your employer how many deductions you are planning to take, and how much should be withheld from your income. Workers often put down zero because they are overwhelmed with paperwork on their first days on a new job and leave it unchanged until they move jobs. Other times, they maximize the deduction based on family members, which leads to a larger monthly paycheck but a cost down the road come tax time. Many taxpayers completely ignore how choosing the right withholding actually affects their take-home income.
With the proper calculation and a simple review—even at the middle of the year—taxpayers can remove the biggest stress of tax season: the question of either how much they owe or how much extra money for investing or spending they missed out on during the year. Tax season can feel like a regular event with less worry. Using the W-4 properly should help avoid surprises come April 15.
But the realities of the modern economy, especially for the self-employed or for joint filers, make the W-4 calculation a bit more complex than in the past. For a single worker with one job, there may not be that much to do. But for someone who also has self-employment income in addition to wages or those filing jointly, the extra or the spouse’s income makes properly calculating the W-4 an important step in tax preparation.
First, let’s look at how this impacts self-employment income. For a taxpayer who also receives self-employment income—either through a spouse with their own business or through a second job working in the gig economy, like an Uber driver—putting in a lower deduction could provide a real benefit down the road. That extra income comes in without tax withholding, sout the law requires that earners provide estimated quarterly tax payments so that all the money doesn’t have to come due on April 15. But increasing withholding at your W-4 job may offset some or all of your self-employment income tax liability.
Tax law expects that you keep your taxes up to date regularly, not just once a year. Anyone who doesn’t meet the estimated payment requirement will face an added effective penalty for the delay, even if they send in all the money owed on April 15. This penalty would apply even if one ends up owed a refund at the end of the year. By properly calculating and allocating extra funds for your self-employed job within your W-4 withholding, you can avoid this penalty.
Second, the joint filer has a separate problem. The joint return takes you out of the vacuum of just being concerned with your own income and forces you to calculate your partner’s incoming money into that mix. While the extra income is certainly welcome, failing to account for it throughout the year can result in a significant payment due. Properly allocating your W-4 income can alleviate or eliminate this problem. What does this mean? Not only should you check your W-4, but maybe it’s time for your partner to review their W-4, too.
Beyond examining your own issues, taxpayers need to be mindful of the most basic tax changes that are coming down the pike and use the W-4 to head them off before a problem arises. For example, this year is unique due to the end of the extra stimulus monies affecting refunds. As a result of this benefit that has shaped tax planning for the last two years, your 2022 tax return will go back to pre-Covid-19 calculations. Additionally, the child tax credit—which increased to $3,000 per child (or $3,600 if the child is under 6) from $2,000—will return to the lower amount. The impact of this can be significant, and spreading it out across the course of the year by reworking your W-4 could help limit any surprises.
One of the advantages of trying a new withholding allocation is that it is something a taxpayer can easily do themselves. How often can you change a W-4? There is no limit. Human resources may get annoyed, but all they are doing is changing the paycheck calculation.
The W-4 withholding is an easily overlooked part of the tax planning process, but at a moment when taxes are not on your mind, calculating your best method going forward may pay off in the long term. Whether your desired way of paying is more money now but pain down the road, less today but a big bonus come tax time, or breaking even and so tax season is not that unpleasant, the W-4 is the way to plan this out.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Jody Padar, CPA, is head of tax at April, an intelligent tax platform. She is the author of “From Success to Significance: The Radical CPA Guide,” “The Radical CPA: New Rules for the Future-Ready Firm,” and “Botkeeper for Dummies.”
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