Tax Withholding: Adjusting Your Payments for Optimal Results

Did you owe Uncle Sam a good chunk of money at tax time last year? Or maybe you received a big refund. Both are signs that it's time to adjust your IRS tax withholding.

Your withholding is the amount of money your employer takes from your paycheck to cover your federal income taxes. The goal is to make sure that the government takes enough money from your paycheck each year that you won't owe it any money when your income taxes are due the following year.

But you don't want the government to take too much money out of each paycheck, either. If that happens, you’ll get a big refund at tax time. That might seem like a good deal. But it makes more financial sense to keep more of your money with each paycheck instead of sending it to the federal government throughout the year, only to then receive it in one big sum after filing your income taxes.

Here’s the good news: Whether you overpaid the federal government last year or underpaid, you can fine-tune the amount of money that your employer takes out of each paycheck by adjusting your financial and filing status on the new IRS Form W-4.

Making these changes could pay off by leaving you with more money with each paycheck or by making sure you don’t owe the government a big chunk of change next Tax Day.

Pros And Cons

There are plenty of pros involved with adjusting your tax withholding. You’ll make sure you don’t give the government too much money each year. That will leave you with more dollars in each paycheck. You’ll also reduce the odds that you’ll have to pay the IRS any money when you file your income taxes each year.

The cons? Adjusting your withholdings does take some research and work. Dealing with IRS forms is intimidating for many. And if you’ve gotten used to a big refund, you might be disappointed not to receive one after you make your adjustments.

But remember: It’s smarter to keep more of the money you earn than it is to send it to the government in the hopes that you’ll get a big refund.

Why Withholding Matters

You first fill out an IRS W-4 form when you start working with a new employer. Your employer uses the information on this form to determine how much money to withdraw from each paycheck to cover your yearly income taxes.

In the past, employees were required to choose the number of withholding allowances -- a number from 0 to 3 – they wanted. The lower the number employees chose, the more money the IRS withheld from each paycheck.

Starting in 2020, though, the IRS introduced a new version of the W-4 Form that does away with withholding allowances. You must now provide financial information, such as how much income you expect to earn from sources other than your job, and your tax filing status – single, married filing separately, married filing jointly or head of household -- on this form. Your employer will then use this information to more accurately decide how much money to funnel from your paychecks to the federal government to cover your income taxes.

The IRS said that it made the change to do away with the uncertainties that surrounded choosing withholding allowances. Taxpayers rarely knew which number to use, and often chose one that would result in employers taking too much or not enough money out of their paychecks.

Your goal with the new W-4 form, though, is the same: You want enough money withdrawn from each paycheck so that you don’t owe taxes on Tax Day and not so much that you’re owed a big refund from the IRS.

You might think getting a big refund is a nice financial reward. But it’s not. It just means that you lent the federal government a big chunk of your money throughout the year in the form of an interest-free loan. It would have been better to have more money with each paycheck, money that you could have invested or saved on your own.

Of course, you don’t want to have too little money withheld, either. If that happens, you’ll owe the federal government money come Tax Day. And paying Uncle Sam is never fun.

The New W-4

The good news is that you only have to worry about the new W-4 form if you’re starting a new job or if you’ve gone through a significant life change. If either of these describes you, you’ll want to fill it out. It’s the best way to tell your employer how much money to withhold from your paycheck for taxes. Taking this step can improve your personal finances throughout the year.

If you don't fill out the form when taking on a new job, your employer must treat you as if you’re claiming the standard income tax deduction for single taxpayers and that you have no dependents. This could result in incorrect withholdings -- you might even owe the government on Tax Day -- if you don’t fit into that category. If you’re married and filing jointly, for instance, or if you have dependents, your employer might not withhold enough, or might take away too much, money from each check if it’s treating you as a single taxpayer without dependents.

If you began working for your employer before 2020, and you haven't gone through any big life changes such as getting married or having children, then you won't have to fill out the new version of the W-4. Your employer will continue to use the information on the W-4 form you filled out when you first took your position. Your company will then handle your withholdings as it has in the past.

If you have gone through a big life event, though, you might want to tell your employer that you’d like to fill out a new W-4. Big life changes include getting married, having children or taking on a side gig that pays you extra income. Filling out the new W-4 form with this information will lower the odds that your employer will withhold the improper amount of money from your paychecks.

Filling It Out

The new W-4 form – you can see a sample of it here -- comes with five steps. The first step is straightforward: This is where you enter your name, Social Security number, address and tax filing status. If you want the maximum amount of withholding for your filing status, you can skip to the fifth and final step. That step is simple, too: It just requires your signature.

Steps two through four are optional. You can skip them if you want your employer to withhold the full amount of taxes from your paycheck based on your filing status. This amount will change, of course, depending on whether you file as a single taxpayer, married taxpayer filing separately, married taxpayer filing jointly or head of household.

Many taxpayers can take this easier route. But those with more complicated economic situations or those who have experienced recent life changes should complete the extra steps in the new W-4 form. If they do, their employers can withhold a more accurate amount of dollars with each paycheck.

What counts as a more complicated economic situation? You might have several dependents. Maybe you can claim a large number of itemized deductions. Or maybe you work more than one job or rely on more than one source of income. And life changes? If you got married or had children, you should compete the extra steps.

Taking The Extra Steps

Filling out step 2 is a bit more complicated. But, again, the extra effort is worth it if you want the most accurate withholding.

This step is designed for taxpayers who have working spouses and work more than one job. If you choose to fill out this step, you have three different ways to calculate your withholding amount.

First, you can use the IRS' online withholding estimator, which you can find here. This might be the simplest option.

You can also use the Multiple Jobs Worksheet. This is a document attached to the new W-4 form that will guide you through the process of estimating your withholdings.

Finally, you can check the default box at Step 2(c). This works if both of your jobs pay about the same amount each year or if both you and your spouse work just one job apiece and your incomes are about the same.

If you are claiming any dependents, such as your children, you'll fill out Step 3. This will tell your employer how many dependents you’re claiming so that your company can more accurately withhold income from your paycheck.

To do this, multiply the number of child dependents you’re claiming by $2,000. Enter that amount in the correct line on the form. Then multiply the number of adult dependents you’re claiming by $500. Enter that amount, too. Then add both figures and enter the result on line 3 of Step 3.

That leaves one more optional step. You'd fill out Step 4 on the W-4 if you earn additional income that isn't taxed, like from investments or a side gig as a freelancer or independent contractor.

To complete this step, fill in the amount of money you expect to earn from these sources during the year in Step 4(a) on the W-4 form.

There's also a section here, Step 4(b), that you'd fill out if you want to itemize your deductions instead of claiming your standard deduction at tax time. To fill out this step, you'll need to use the Deductions Worksheet, which is on page three of the new W-4 form. After you complete this worksheet, you can enter the right number in Step 4(b).

Summary

Completing the new W-4 form might seem intimidating, whether you typically do your taxes on your own, work with online filing software or hire an accountant or tax preparer. But doing so isn’t as complicated as you might think. And taking the extra week could mean more accurate withholdings.

The bottom line: Don’t let your fear of the new form intimidate you. You don’t want to give the government too much, or too little, money during the year. Boost the odds that this won’t happen by filling out the new W-4 if you’re starting a new job or have gone through significant life changes.

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