If you're like most people, you've probably looked at your pay stub and noticed that the difference between your pre-tax earnings and take-home pay is significant. While it’s tempting to meddle with your income tax withholding to make the gap between earned income and your net pay smaller, adjusting your withholding so that your employer withholds less taxes each paycheck won't change your tax obligations -- and therefore, you're likely to see changes in your end-of-year tax bill.
Federal Income Tax Withholding
When you begin a new job or your financial circumstances change, you submit a Form W-4 that outlines your allowances from income tax. Generally, the more allowances you claim on your W-4, the less in taxes your employer will withhold each pay period. While these allowances may help you fine-tune your income tax withholding, it’s also possible for you to miscalculate so that your employer doesn’t withhold enough income taxes from your paycheck. If this happens, you’ll owe the Internal Revenue Service the balance when you file your federal income taxes.
Payroll taxes, which are also known as FICA taxes, are mandatory withholdings made from your paycheck, and even if you claim exemption from income tax withholding on your W-4, your employer still must withhold your share of FICA taxes. As of 2012, FICA withholding consists of 4.2 percent of wages for Social Security – temporarily lowered from the customary 6.2 percent – and 1.45 percent for Medicare. Although the IRS checks that your FICA withholding was correct when you file, you generally can’t do anything to adjust this tax rate.
Pay-As-You-Go Income Taxes and Refunds
The federal income tax system is designed to be a pay-as-you-go system, which means most employees are expected to pay their share of taxes through withholding as they earn the income. If you overpay your income tax through the year, you receive a refund of your overpayment in the form of a refund check. If you underestimate your withholding, you must pay the difference when you file. Depending on your circumstances -- for example, if you receive significant income as an independent contractor, which isn't subject to withholding -- you may be expected to make quarterly estimated tax payments.
Penalties for Underpayment
If you don’t contribute enough in payroll withholding or you fail to pay enough through estimated tax payments, you may owe a penalty for underpayment of estimated tax. The rules are complex and depend on the circumstances. For example, if you owed less than $1,000, you won't owe a penalty. Alternatively, if your withholding was considered "close enough" -- which the IRS defines as 90 percent of your tax bill -- you won't owe a penalty, either. Likewise, if you paid or had withheld 100 percent of the previous year’s taxes, you don’t owe a penalty, even if this year's taxes are substantially higher. If you don't fall into any of these categories, the IRS assesses an additional charge for not keeping up with the pay-as-you-go method. Calculating this penalty is complicated, but Form 2210 provides a worksheet to calculate your penalty.
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