Payroll in Practice: 5.1.2023

Question: Employees might have nonwage income and tax payments that can affect the amount that needs to be withheld from wages. Can the employee factor these items into Form W-4 so that wage withholding more closely aligns with the employee’s overall tax situation?

Answer: It is possible to factor nonwage items into Form W-4, Employee’s Withholding Certificate.

Prior to 2018, the withholding allowance amount was aligned with individuals’ personal and dependent tax exemptions. Employees with a simple tax situation could expect tax withholding that approximated their actual tax liability by claiming withholding allowances based on the number of tax exemptions they were entitled to claim. The standard deduction was built into the tax tables.

Employees with more complex situations could adjust the number of withholding allowances, as well as claim additional withholding, to have an appropriate amount withheld. Complicating factors might include other income sources, gains and losses, tax credits, additional taxes such as the self-employment tax, and other tax payments such as withholding on nonwage payments and estimated tax payments.

After 2017, under the Tax Cuts and Jobs Act, personal and dependent exemptions were suspended and set to zero. The use of withholding allowances became less intuitive and accurate as a tool for estimating the amount that should be withheld from an employee’s pay.

The current version of Form W-4 Form, which went into effect in 2020, allows employees to take additional factors into account based on expected annual amounts. It provides most of the information necessary to compute the amount to withhold within four steps on the form. The fifth step is for the employee to sign and date the form.

The remaining required information is the employee’s gross income tax wages and the pay period (weekly, biweekly, semimonthly, etc.). As with tax tables prior to 2020, standard deduction amounts are built into the tax tables. The four steps are as follows.

Step 1. In addition to the employee’s name, address and Social Security number, the employee indicates filing status. This tells the employer which marital status tables to use to compute the amount to withhold. There are three marital status categories: single or married filing separately, married filing jointly, and head of household.

Step 2. A box can be checked if the employee, and spouse if married, have a total of only two jobs. It works best if the two jobs pay about the same amount. The box must be checked on both Forms W-4. The standard deduction and tax brackets are cut in half for each job to calculate the withholding.

If the box is not checked, Step 2 provides instructions for making an adjustment to gross income for the highest paying job when there are multiple jobs, The adjustment shifts the income into the appropriate tax brackets. Steps 3 and 4 should be filled out on the W-4 of the highest paying job but left blank on the forms for the other jobs.

The multiple jobs calculation should not be used for nonwage income, even if taxes are withheld from that income, because the withholding computation methods are not the same.

Step 3. The employee enters amounts for the child and other dependent credits to which they are entitled. Other tax credit amounts can be added to the child and other dependent credits. For example, foreign tax, energy, and education credits.

Step 4(a). The employee should include nonemployment income the employee wants included in the withholding calculation. This could include self-employment or farm income, investment income including rental property, retirement income, or Social Security benefits.

In many cases, this income may be covered by estimated tax payments or back-up withholding. In the case of third-party sick pay, unemployment compensation, retirement, or Social Security income, voluntary withholding can be requested using Forms W-4P, W-4S, or W-4V. Income for which the employee is making estimated tax payments or from which tax is being withheld should not be included in Step 4(a).

Step 4(b) is for deductions or losses, other than the standard deduction, that will reduce taxable income and reduce the amount withholding required. There is a worksheet in the instructions for this step.

Step 4(c) is to enter any additional amount of withholding per pay period to cover the employee’s estimated tax liability for the year.

For complex situations, the employee might find it helpful to use the IRS’s tax withholding estimator. The estimator provides an adjustment to enter in Step 4(c) for any additional amount of withholding required. This also eliminates the need for employees to enter any other information in Steps 2, 3, or 4 or otherwise disclose information about their tax situation to the employer.

The tax withholding estimator provides a number to enter in Step 4(c). Once that number is entered, the employee needs to complete only Steps 1 and 5.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.