As CPAs, we are often asked about federal tax withholding — “How do I know if I am withholding the correct amount?” or “If I change my withholding amount, will I owe less at tax time?” By understanding how federal tax withholding works, you can avoid a surprise during tax season.
How does tax withholding work?
The Federal income tax is a pay-as-you-go tax, meaning you are expected to pay tax on your income as you earn it throughout the year. At year end, your actual tax bill is calculated, based on not only your income, but also any life events, dependents, your filing status, charitable contributions, deductions, and other factors. If your payments throughout the year were greater than the actual amount owed, you’ll receive a tax refund. If you underpaid, you’ll owe the remainder to the IRS.
Throughout the year, payments can be made in two ways: by withholding from your paycheck, pension, or social security payments; or by making quarterly estimated tax payments (people who are self-employed generally pay their tax this way).
Avoiding a surprise
If your tax bill this year was larger than you expected, you may need to adjust your withholding amount or make estimated tax payments. It’s especially important to check your withholding if any of the following life changes occur:
- Lifestyle changes – marriage, divorce, birth or adoption of a child, home purchase, retirement, filing chapter 11 bankruptcy
- Changes in wage income – if you or your spouse start or stop working, or starts or stops a second job
- Changes in taxable income not subject to withholding – interest, dividends, capital gains, self-employment, and gig economy income, and IRA (including certain Roth IRA distributions)
- Changes to itemized deductions or tax credits – medical expenses, interest expense, gifts to charity, dependent care expenses, education credit, child tax credit, or earned income tax credit
- Married couples with significantly different levels of income – if one spouse makes $300,000 annually, and the other spouse makes $80,000 annually, most of the couple’s income will be taxed at 22-24%, but the person making $80,000 is likely being withheld much lower than that.
Now is a great time to do a “withholding check” to ensure that your federal tax withholding amount is correct for the year ahead. Your CPA can help you determine if you need to make any changes. You can also use the tax withholding estimator tool on the IRS website to estimate your current income tax, and compare that to your current federal tax withholding to help you decide if you need to change your withholding amount. State withholding is separate and varies depending on the state you live in.
If you have questions about tax withholding, leave a comment below or feel free to contact me directly. I’m happy to help!