By AnnaMarie Mock, CFP®
Benjamin Franklin wisely observed that “nothing can be said to be certain, except for death and taxes”. Centuries later, this still rings true. Most earned income will be subject to taxes and tax withholding as determined by Form W-4, Employee's Withholding Allowance Certificate.
Form W-4
Form W-4 is an IRS form you, as an employee, complete directing your employer on the amount of pay to withhold from every paycheck for federal taxes. Accurately completing your W-4 is beneficial to you because it can prevent overpayment of your taxes, putting more money in your pocket. It can, also, avoid underpayment of your taxes, which ensures that there will be no unexpected tax bill or penalty due.
Tax Allowances
On Form W-4, you indicate the number of allowances to claim. You will get one allowance each for yourself, spouse, and all dependents reported on your tax return. Less tax will be withheld with more allowances claimed. Form W-4 includes a series of worksheets to calculate the appropriate number of allowances.
You can obtain a copy of Form W-4 by visiting the IRS website. You have to provide some personal information and your withholding election on the form before giving it to your employer for processing.
When to Check Your W-4
Most individuals will complete their W-4 when first hired and then never review it again. In addition to new employment, there are some life events that may have a direct effect on the amount of tax owed. At a minimum, you should review your withholding during these major life events:
Additional Employment: The IRS recommends that if you have multiple jobs or you and your spouse both work, you should claim all of the available allowances on the Form W-4 for the highest paying job and claim zero on the remaining jobs. You can, also, withhold additional monies from your pay, which may benefit individuals that have multiple forms of employment, a dual income household, or are self-employed. Any changes in household income could affect your marginal tax bracket because any additional income reported on your tax return may put you in a higher tax bracket. By voluntarily increasing your tax withholding on your W-4, you can avoid having to make an additional lump-sum tax payment when you file and possibly avoid an under withholding penalty.
Marital Status Change: Your tax rate is subject to change either through marriage or divorce. If recently married, you will be able to file the current year’s tax return as married filing jointly, which may qualify your household for a lower tax rate and other deductions not eligible for single filers. If your overall household income increases through marriage, you may have to increase withholding, but if one spouse is not employed, it may result in a lower tax rate and less withholding. Through divorce, it will revert the tax filing status back to single for each individual. If this is not accounted for on your W-4 by adjusting allowances, your withholdings could be insufficient.
Birth or Adoption of a Child: A new baby is more than a bundle of joy! You can claim your child as an additional allowance and potentially obtain other tax credits. You should capture the additional exemption on the Form W-4 as this may reduce your overall withholding. If no changes were made, you may be getting a sizable tax refund instead of reaping the benefits in each paycheck.
Tax Overpayment (Refunds) and Underpayment
Although many consider tax refunds as a windfall for the year, it may not be the best use of funds because it means you overpaid the government. There’s an opportunity cost to the overpayment as you may have earned more being invested in long-term investments or even being deposited into a high yield savings account.
Underpayment of taxes can cause a disruption in your cash flow because of the potentially large tax bill and penalty. If 90% of the tax due for the current year or 100% of prior year’s tax is not withheld, then you can face a penalty of 0.5% of the amount due per month up to 25% plus interest costs and the amount underpayment.
As the new year approaches and your life evolves, consider reviewing your Form W-4 to ensure that your taxes will be sufficiently satisfied for the coming year. If you have any questions, please feel free to reach out to the HIGHLAND team.
Author’s Bio
AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.