Withholding Tax – The Goldilocks Method

Withholding tax
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Making your tax return “just right”!

“I’m not getting a refund because I’m just not taking advantage of all the loopholes”

“My neighbor always gets a huge refund every year, and I have to pay; what’s the deal with that?” While tax preparers vary by ability, it’s more about the set-up of your withholding tax.

A big, fat refund on your taxes means you’ve been loaning the government too much of your hard-earned cash with each paycheck. Uncle Sam is merely returning money that was yours, to begin with—that’s why it’s called a refund!

With every paycheck, your employer withholds Federal and State tax income tax (as well as other taxes).  Tax withholding is simply the chunk of money your employer sets aside from each paycheck to cover your taxes.  Therefore, withhold too much, and you’ll get a tax refund. Withhold too little, and the IRS sends you a bill.  In my opinion, the goal is to get as close to “$0” as possible.  (More about that later).

The 2018 Tax Filing Season was a trainwreck!

During the 2019 filing season, the IRS had plenty of unhappy customers. The reason is that many people who were used to getting tax refunds were shocked to discover that they had to pay taxes when they filed their 2018 tax return. And by that time, it was too late.

The 2017 tax reform law reduced tax rates, doubled the standard deduction, and increased the child credit, which lowered the overall tax bill for many people. But . . . the IRS over-compensated and reduced the amount of tax withheld from wages to synchronize withholding with these tax law changes. As a result, people didn’t have enough tax taken out of their paychecks in 2018 to cover what they owed.  Many found they STILL owed money even though taxes went down.

Congress changes the W4

In an effort to fix things, Congress decided to re-do the form used to determine withholding, the W4.

For as long as I’ve been on the planet, the W4 asked us to select the number of withholding allowances to use for taking money out. But this always brought about lots of questions and uncertainty. Figuring out how many allowances to claim has always been a big headscratcher.

Thankfully, the new form nor longer asks for that number and figures the amount of withholding based on your answers to various questions. Nevertheless, as Pete Isberg, Vice President of Government Affairs for payroll processor ADP, notes, “withholding allowances have been the basis of payroll withholding forever,” so the change is likely to “cause a little confusion.”

The Re-Design ‘makes accurate withholding easier . . .’

“The new design reduces the form’s complexity and increases the withholding system’s transparency and accuracy. While it uses the same underlying information as the old design, it replaces complicated worksheets with more straightforward questions. This makes accurate withholding easier for employees,” says IRS.

How to Ensure Correct Withholding Tax

How do you make sure you don’t give our beloved Treasury too much money? For a moment consider Goldilocks’ experience . . . withhold too much and wait to get your money back, withhold too little and get that April 15th surprise, or withhold just right and get full use of your money!

It starts with filling out the new W4 correctly.

Withholding tax - the new W4
The New W4

Since there are no longer exemptions on your tax return, there are no longer exemptions to claim on the W4 form.

The new form asks various personal financial information that impacts the amount of withholding. The more information you provide, the more accurate will be your withholding.  

For instance, if you are married and both of your work, there are three options you can use to calculate your withholdings. The goal with each of the options is to determine how much to put on line 4(c).

Withholding Tax - IRS Estimator
IRS Withholding Tax Estimator

Method 1 = Use the estimator @ www.irs.gov/W4App. This method is the most accurate.

Method 2 = Use the Multiple Jobs Worksheet (part of the 4 page W4 form). 

Method 3 = Use if there are only two jobs. Check the box on both W4s. The payroll system will properly withhold additional tax to account for the combined income of the two.

There are two methods to choose from when manually preparing payroll:

IRS Publication 15-T: https://www.irs.gov/pub/irs-pdf/p15t.pdf

The Wage Bracket Method

For earnings up to approx—$ 100,000 per year. If wages are above $100,000, use the Percentage Method (below). The wage bracket method of calculating withholding tax is the simpler of the two methods. You’ll use the IRS income tax withholding tables to find each employee’s wage range. The instructions and tables can be found in IRS Publication 15-T.

The Percentage Method

Allowed for ALL wages amounts.

The federal income tax has seven tax rates for 2020: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent.

Rule of thumb for Married Filing Joint:

Married couple, no kids, “standard deduction.”

  • Gross income of $44,550, you’ll pay a max of 4.4%, or $1,975.
  • Gross income of $105,050, you’ll pay a max of 8.8%, or $9,235.
  • Gross income of $195,850, you’ll pay a max of 14.9%, or $29,211.
  • Gross income of $351,400, you’ll pay a max of 18.9%, or $66,543.
  • Between each of the Gross income numbers, you’ll pay somewhere between the % noted.
  • If you have kids or itemized deductions greater than $24,800, your taxes will be less.

Monitor your withholdings!

Are you ahead of the game, or behind? What to do?

You should review your paycheck stub throughout the year. Note the amount of withholding tax YTD and ask yourself if it is reasonable. Then around Sept 1st, project your YTD withholding to the end of the year and compare that to your prior year’s tax return.

Does it look like you’re paying in enough?  Do you need to increase it? To make an adjustment change the amount on line 4(c) of the W4.  The other option is to meet with your tax preparer for a detailed calculation. Do this with enough time left in the year to make the changes you need.

In conclusion, the result is up to you.  YOU are in control, not the government. Knowing how the system works allows you to tailor your paycheck withholdings to your needs.

And knowing no big surprise awaits you will give you peace of mind, and that’s worth a ton!