How Does Withholding Work?

The 2020 Form W-4 was significantly changed by the IRS and the beginning of the year is the perfect time for every employee to review their income tax withholding set for the year. Are you an employee who received a refund when you filed your 2018 tax return? A tax refund so commonly viewed as a bonus or free money, but in reality, a tax refund is really just your money that you loaned to the IRS throughout the year and they are paying back the loan. If you receive a tax refund, the IRS was never entitled to that money in the first place. I personally am not a fan of loaning the IRS my money interest-free for months at a time and my goal is to have no refund or additional tax due when I file my tax return. This is difficult to get perfect but the best way to get close is to keep your W-4 updated with your employer.

There are many generally misunderstood aspects of the United States income tax system but one of the most confused and misunderstood items is income tax withholding and what tax refunds really are. Most Americans receive the vast majority if not all their household income through a salary. The federal income tax system requires that you pay your taxes regularly, not just annually on April 15th and there are actually penalties and interest assessed if the tax is not paid in regularly throughout the year. Most employees do not know that taxes are required to be paid in regularly because their employer takes care of this requirement for them through payroll.

Among the stacks of paperwork HR requires you to fill out on the first day of your new job is Form W-4. This form is used to tell your employer approximately how much income tax to withhold and remit to the IRS each and every pay period. If the employer examines your salary, marital status, and other Form W-4 information and determines you will owe $10,000 in income taxes they will withhold a total of $10,000 throughout the year from your paychecks and remit the withholding to the IRS on your behalf. When you file your tax return, you are comparing what the tax return calculates as your total tax versus what you have paid in ($10,000) to see if you owe more than $10,000 and need to write a check or less than $10,000 and are entitled to a refund.

The New 2020 Form W-4

Gone are the days of “allowances”. The IRS did away with the concept of allowances on the 2020 Form W-4. This was in large part due to the sweeping Tax Cuts and Jobs Act passed on December 22, 2017 which removed the deduction for personal exemptions. The new W-4 uses dollars instead of allowances which is arguably an improvement as it should be more user friendly and intuitive.

The new form is one page and has five steps. Step one and step five are required and steps two through four are optional depending on your circumstances. For most people the last time you saw Form W-4 was the last time you started a new job, but the IRS encourages taxpayers to look at their tax situation annually to see if filing a new Form W-4 with your employer would be beneficial.

Why File a New W-4?

Why would you go through the trouble of looking at this annually? If there are any changes in your personal life, your income, or your tax deductions you should consider filing an updated W-4 with your employer.

David and Susan are married with no children and both work as employees in local businesses. In February of 2020 David and Susan have their first child and being new parents is enough to deal with, so they do not think to fill out a Form W-4 with their employer, who would? David and Susan now qualify for the $2,000 child tax credit and so when they file their tax return in April of 2021 their total refund is $2,500 which excites them greatly. However, had they filled out a new W-4 in April they would have been able to receive this $2,000 credit through their paychecks during the year instead of loaning it interest-free to the IRS all year and the IRS repaying that “loan” in April of 2021.

Other reasons to file a new W-4 would be getting married or divorced, buying a house, increased charitable giving, large interest or dividend income, or you or your spouse have side freelance income. My wife and I decided to open a donor advised fund and “bunch” our charitable giving every other year to maximize the standard deduction. This created a relatively significant 2020 tax difference and so I filed an updated W-4 showing the increased deductions on line 4(b) to let my employer know to withhold less income taxes from our paychecks. I used the IRS withholding estimator which is their online calculator to help project your future refund on tax due.  

Exempt Filers

The IRS provides single filers with a standard deduction of $12,400 and married filers with a standard deduction of $24,800. This means that if you do not have income greater than these thresholds you will not owe any income taxes and most likely are not required to even file a tax return.

However, if your employer withheld income taxes from your paychecks you will want to file a tax return to claim your refund. If you know you will make less than the threshold you should write “Exempt” below step 4(c) on the 2020 Form W-4 to let your employer know to not take out any income tax withholding. This will prevent you from having to file a tax return just to claim your small refund of tax.

Conclusion

Thinking about taxes is no fun and neither is running a projection on your income and filling out a new W-4. However, the difference between updated Form W-4 or not could mean thousands of dollars going to the IRS to sit in their bank accounts for months waiting for you to file a tax return and ask for it back. The IRS has developed a rather extensive withholding calculator that is very helpful in giving you a general idea of whether you will receive a refund and what size it might be. The beginning of the year is the perfect time to project your income and I encourage you to do a check up before you get busy filing your taxes in the next couple of months.