In the U.S. tax system, most individuals take the pay-as-you earn (PAYE) approach, in which estimated income tax is paid throughout the year and then accounted for on tax day of the following year. It's not as if they have a choice. Their employers are legally required by the federal government to withhold part of their employees' income for taxes by deducting a portion of their regular paychecks.
To calculate the precise amount they withhold, employers rely on the information all new employees fill out on their Form W-4 forms. If too much tax is withheld, employees receive refunds.
Events That Trigger Changes
The amount of taxes withheld is governed by the following considerations:
Whether you file for a "married" or "single" rate on your W-4
Whether you wish to withhold extra funds
The number of allowances you qualify for3
Changes in your household situation, such as the birth of a child or a spouse losing a job, can immediately impact your tax situation. In these situations, it is well worth changing the amount of withholding, to avoid owing a bigger tax bill than necessary.
Will You Marry Me?
If you are married and filing a joint tax return, your taxes may be impacted in the following two ways:
If your spouse earns an income, your overall household withholding may increase.
If your spouse doesn't work, your overall withholding will likely decline.4
(There are situations in which separate filing makes sense.)
You Ruined My Life and My W-4!
Divorce can alter your household income, but there is also the matter of alimony, which began receiving a different tax treatment starting in 2019, thanks to the Tax Cuts and Jobs Act that was signed into law in 2017. Under the new tax paradigm, alimony payments will no longer be tax-deductible for the payer, while recipients do not have to declare alimony as income.5
Baby Makes 3
The birth or adoption of a child immediately adds a dependent to your household and lessens the overall tax burden, in an effort to compensate for the costs of raising children.
When your children grow up and if they move out, you must readjust your withholding.
New Digs or New Deductions
When purchasing a home, you must update your withholding to lock in a tax break. Of course, you can leave this task until the end of the year, but you will lose out on opportunity costs. This holds true with any large deductions or credits you may become eligible for within a given year, including education credits, dependent care expenses, and charitable donations.3
Big Increases in Non-Wage Income
You must adjust your withholding to account for any non-wage income from side businesses, stock dividends, interest income, and so forth. If more taxes aren't withheld throughout the year to reflect this supplementary income, your bill at tax time can be jarringly large.3
Working 2 Jobs
According to the IRS, two-income households and individuals who work multiple jobs are vulnerable to withholding disparities.6 If you are working two jobs, you may split your allowance between them, but you cannot claim the same allowances twice.
Similarly, losing a second job allows you to reduce the withholding on your remaining job or claim allowances you were previously holding off on.
Getting Your Withholding Right
The IRS provides features a useful withholding calculator on its website: IRS.gov, and provides worksheets for converting credits to withholding allowances. The site also offers tips to avoid common errors.7
While you cannot claim the same allowances as your spouse, you can split them up as needed.
The Bottom Line
People may go years without the need to significantly alter their withholding status. But when life changes do occur, it's worth taking the time to re-file the W-4. If you pay out too much to the government throughout the year, you will be refunded. But if you pay out too little, you may be surprised by a large bill.
Reprinted from Investopedia
By ANDREW BEATTIE