What are tax withholdings and tax deductions?
On your paycheck stub, you’ll find several items that represent money deducted from your paycheck. These tend to fall into two categories: withholdings and deductions. Withholdings are taken out of your paycheck to cover the amount of income tax and other federal and state taxes you owe. This includes money deducted for Social Security, Medicare, federal and state income taxes. Deductions are taken out for your portion of workplace benefits and charitable contributions. For example, you may have a deduction to pay for part of your health insurance plan or your 401(k) contribution. So, you start with your gross pay, then your withholdings and deductions are subtracted until you’re left with your net pay, which is the pay you bring home.
Who determines federal withholding tax?
For federal income taxes, Social Security, and Medicare, your employer follows a formula supplied by the IRS to determine how much to withhold for taxes from your paycheck. For state income taxes, your employer is provided a formula by the state. In general, the formula for how much to withhold for Social Security and Medicare is pretty precise. However, with income taxes, it’s hard to be quite so precise; the amount of taxes you owe on your income varies depending on how much you earn as well as how many tax deductions you can claim when you file. If, for example, you have a lot of tax deductions, you’ll end up owing less in taxes, which means there’s more money taken out of your paycheck than necessary. You’ll get that money back as a refund after you file your taxes the following year. If, however, you have another job, you may not have enough withheld from your paycheck. You will either break even or owe money in that case. The formulas err on the side of taking out a little more than necessary, as most people should receive a refund in April than have to suddenly pay an extra tax bill. But the formulas aren’t perfect for all situations.
What’s the importance of the W-4 form?
One big part of the income tax formula comes from the information you give to your employer when you start your job. On the first day at most jobs, you must fill out a Form W-4, known as an Employee’s Withholding Certificate. It tells your employer how many people are dependent upon your income, which determines how much tax you pay. These are called “allowances.” You can claim one allowance for yourself, as long as no one else claims you as a dependent. You can claim one allowance for every dependent other than yourself or your spouse (usually, this means children). You can claim either zero or one allowance for your spouse. You can also claim one more allowance if you file your taxes as the “head of household,” meaning you’re unmarried and paid more than half the cost of maintaining your home this year. The more allowances you claim on your W-4, the less money will be taken out of your pay for federal and state income taxes. You’re allowed to say whatever you want on your W-4 form. All it changes is how much is withheld for taxes from your paycheck. If you put an allowance number lower than your actual allowances, they’ll withhold more from each paycheck and you’ll have a big refund. If you put an allowance number too high, they’ll withhold less from your check, but you’re likely to owe money when you file your taxes. In general, the best move is to be as honest as possible on your W-4 form.
Why shouldn’t I put a high number of allowances on my W-4?
One plan that many people consider is simply claiming a high number of allowances on their W-4 so that their employer takes very little out of their paycheck for income taxes. This means that the net income they receive throughout the year is a little larger, but they’ll have to pay an income tax bill the following April. Some try to “guess” how many allowances they can claim to get their tax withholdings lowered while still hopefully covering their full tax bill. The drawback of this plan is that you’re likely to end up owing money to the IRS out of your pocket next April, and the IRS is serious when you owe them money. With 78% of American households living paycheck to paycheck, an extra tax bill can cause a financial crisis in most homes. It’s not worth tinkering with these withholdings just to have an extra $20 or $30 in each paycheck; the consequences of not having enough to pay your tax bill the following April can be disastrous. What about a plan in which you put some money aside in a savings account each week to pay your tax bill instead of having it be withheld? On paper, this seems like a great idea: You put some money in a savings account each week, it earns interest, then you use that money to pay your tax bill. The remaining money in the account is your immediate “tax refund,” plus the interest. Alas, there are problems with this plan. First, you won’t earn a lot of interest this way. With savings accounts paying half of 1% or less in annual interest, you’ll earn at best $5 for every $1,000 in the account if it sits there all year. It’s not a big boon. If you invest your money in more aggressive investments, such as risky stocks, you risk losing some of your investment, leaving you without enough to pay your tax bill. Second, this plan requires you to calculate the right amount to save each week. If you get it wrong, you may end up still owing money next April, or you may end up putting too much in there, which puts you essentially right back where you were before you started tinkering with your W-4 allowances. Third, you must resist the temptation of touching that money. When the holidays hit, it can be extremely tempting to tap a savings account to buy that “perfect” gift for someone or to travel to an exotic location for vacation. That would leave you without any money to pay your tax bill when the IRS comes knocking in April. Rather than risk so much to gain so little, let your employer do the work using the IRS formula based on your correct number of allowances.
How to save on taxes
Instead of tinkering with your paycheck withholdings, focus on maximizing your tax deductions and tax credits. Use a reputable tax software package that can help you identify all deductions and credits you might be eligible for, or rely on a respected tax preparer such as H&R Block. If you face a tax bill, focus on keeping it low rather than playing roulette with your paycheck withholdings. [This article was originally published on The Simple Dollar in December, 2020. It was updated in November, 2021.]
