How Does My Withholding Affect My Taxes?

Paying income taxes may not be your favorite diversion, but the IRS helps take a bit of the sting out of a high tax bill at the end of the year by using a periodic withholding tax method. It’s a little like making layaway payments on merchandise instead of paying for an expensive item all at once. Whether you’re making layaway payments on an item or paying your income tax bill a little at a time, both payment methods help ease the sticker shock of making one large payment. And with some small tweaks here and there, you may be able to adjust your income tax withholding payments and enjoy more take-home pay with each paycheck.

Two Ways to Pay Taxes

You’ll typically pay your income tax in one of two ways, hinging on how you get paid. If you’re an employee (or if your compensation is from certain non-employee sources such as Social Security or a pension fund), your employer or other payer of funds withholds a designated amount of money as you receive your paychecks (or other type of funds distribution). But if you are self-employed, you are responsible for making your own periodic income tax payments, which typically occur at quarterly intervals during the tax year.

Federal Withholding Meaning for Taxes

The IRS collects income tax from employees with its “pay-as-you-go” system by withholding incremental payments from employees’ paychecks toward their total annual federal tax bill. Ideally, by the end of the tax year, the total amount of these tax payments offsets an employee’s yearly tax liability so that the employee may only owe a small balance to finish paying the total tax bill. In many cases, employees receive a tax refund for the taxes they’ve overpaid.

Federal Income Withholding Allowances

An “allowance” is not a percentage of your earnings or even a specific dollar amount that’s withheld from your paychecks. It’s a specific round number that you compute. In fact, you submit the number of your withholding allowances to your employer, instead of your employer (or the IRS) determining the number for you. This means you have some control over how your withholding affects your taxes – at least in the short term. But you don’t have total latitude to pick out an arbitrary number of allowances. You’ll compute this number by using some IRS worksheets that factor in details of your specific tax situation such as your marital status and number of dependents.

Withholding Starts with Your W-4

You may remember filling out IRS Form W-4 (Employee’s Withholding Allowance Certificate) when you started your job. Or you may have filled out a new W-4 (to replace the original one you filled out) if there has been a change to your financial situation. By submitting this short 10-field form to your employer, you’re essentially letting your employer know how much money to withhold from each of your paychecks. Your employer takes the number of allowances you indicate on your W-4 and converts that number into a dollar amount by performing some calculations. Each allowance you claim means less federal income withholding tax (also called FITW tax) your employer withholds from your paychecks, and more take-home pay for you.

Difference Between W-4 and 1099

If you’re self-employed, you won’t have income tax withheld from your earnings. For example, you may be a landscape designer who earns income from numerous clients. Or you may receive dividend income or Social Security benefits. These examples, plus many more, represent payments or distributions you receive from a non-employer source. Different types of non-employee income have different thresholds at which the payer of the income must report it to the IRS. You’ll fill out one of the forms in the IRS 1099 series for your clients or other payers, depending on the type of income you receive, instead of a W-4, which will keep track of what you earn from a non-employer.

Tip

Even though you furnish your employer with the number of withholding allowances you're claiming, the IRS does not use this number to compute your tax liability. Employers simply use W-4 forms to calculate a best-guess estimate of withholding enough payments throughout the year to meet your year-end IRS-assessed tax bill.

How to Determine W-4 Allowances

The W-4 form includes three worksheets that walk you through a step-by-step process of calculating how many withholding allowances you should claim, which you’ll enter on Line 5 of your W-4. If the W-4 your employer gave you does not include these worksheets, visit IRS.gov/forms to find them.

  1. Personal Allowances Worksheet. On Lines A through D, you’ll enter the allowances you’re claiming based on your filing status and the number of jobs you and your spouse have. On Line E, you’ll enter the number of eligible children you have, which also considers your filing status and total income. Line F is where you’ll enter allowances for eligible dependents other than your children. If you’re unsure whether you can claim someone as a dependent, check IRS Publication 505 (Tax Withholding and Estimated Tax) to see if you qualify. Worksheet 1-6 in Publication 505 will help you determine if you have eligible dependents. View, download or print this publication after searching for it by number at IRS.gov.
  2. Deductions, Adjustments, and Additional Income Worksheet. Not all taxpayers will need to complete this worksheet. It’s only for itemizing deductions (such as qualifying home mortgage interest and charitable contributions), claiming certain income adjustments or including a significant amount of non-wage income. Publication 505 can help you determine IRS-allowable deductions.
  3. Two Earners/Multiple Jobs Worksheet. On the Personal Allowances Worksheet, Line H directs you to complete the Two Earners/Multiple Jobs Worksheet if you have more than one job at a time or if you’re married filing a joint tax return with your spouse and you both work. If either of these conditions applies to you, and your combined income from all jobs is more than $53,000 ($24,450 if you’re filing jointly with your spouse), you’ll want to complete this worksheet. Otherwise, your withholding may not be enough, which means you’ll have a not-so-pleasant surprise when presented with a large tax bill balance at the end of the year.

When to Adjust Your Withholding

Understanding your paycheck and how your withholding affects it can help you fine-tune the number of allowances you claim. For example, if you receive a large income tax refund each year, or if the opposite is true – you wind up paying a large tax bill balance – you may need to adjust your withholding allowances to align more closely with your actual tax liability instead of your estimated tax liability. You can do this at any time simply by submitting a new W-4 to your employer. If, for example, your marital status changes, you welcome a child into your family or you (or your spouse) take on a second job (or either of you begins a new job or loses a job), you’ll want to perform what the IRS calls a “paycheck checkup” by using its online withholding calculator tool.

Using IRS Online Withholding Calculator

Visit IRS.gov, and click the search icon at the top of the page after it loads. Enter "tax withholding calculator" and follow the prompts to access this online tool. You'll need to have a few things at your fingertips, including your most recent pay stubs, your most recent income tax return and the number of eligible children and dependents you can claim. If your tax situation is more complex than most, the IRS recommends following the instructions in Publication 505 to determine your withholding allowances.

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About the Author

Victoria Lee Blackstone was formerly with Freddie Mac’s mortgage acquisition department, where she funded multi-million-dollar loan pools for primary lending institutions, worked on a mortgage fraud task force and wrote the convertible ARM section of the company’s policies and procedures manual. Currently, Blackstone is a professional writer with expertise in the fields of mortgage, finance, budgeting and tax. She is the author of more than 2,000 published works for newspapers, magazines, online publications and individual clients.


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