Tax withholding and estimates is a topic that throws many taxpayers for a loop. It may seem daunting to approach, but there are resources you can use to simplify the process.
The first question many people have is, "why do we have to pay withholding or estimates at all?" The answer is that taxpayers are required to make periodic payments during the tax year, and the tax return at the beginning of the following year is basically a reconciliation between what the withholding or estimated payments were and what your actual tax liability was. If taxpayers do not pay enough during the year, there can be a penalty. This penalty comes into play if you do not pay at least 90% of the current year tax or 100% of the prior year's tax and the balance due is greater than $1,000. The penalty itself is 0.5% of the underpaid amount for each month unpaid up to a maximum of 25%.
There are two primary ways that you as a taxpayer can pay your taxes throughout the year. The first and most common is withholding through an employer. The second method is more common for those who are self-employed or have significant other sources of income besides employment, who make estimated payments.
Withholding for W-2 Employees
The simplest scenario, fortunately, is the most common. If your primary source of income is through salary, wages, and tips as an employee, this process can be simple. The form W-4 is something many people fill out when they start a job and then entirely forget about, but I always suggest to my clients that it be reviewed every year at tax time to ensure they are getting they outcome they want. This is the form that tells your employer how much to withhold from paychecks. It used to be a source of confusion for many people when it forced us to choose seemingly arbitrary numbers that did not have an obvious connection to the withholding amount or our tax returns. However, the IRS revamped the form in 2020 to make it more intuitive and more accurate. There is now a more clear relationship between the form W-4 and the annual tax return. The form asks questions about filing status, dependents, and other income and deductions just like the tax return does.
For more complicated situations such as those with multiple W-2 jobs (including married filing jointly returns where both spouses work), there is a separate section of the form you can complete to do all of those calculations directly on the W-4. The IRS also has a user-friendly, interactive tool that can simplify this process: the Tax Withholding Estimator. From this website, you work through a brief questionnaire, and receive results that advise how to modify the W-4 for the remainder of the current tax year. You need to have the most recent paycheck in the current year on hand to be able to answer these questions.
So which method is better: manually completing the W-4 or using the Tax Withholding Estimator? It will depend on your specific situation. If your income stays largely the same from year to year and you have a relatively simple tax situation with only one or two jobs and relatively small amounts of other income, completing the W-4 manually should not be too difficult. For more complicated situations the Tax Withholding Estimator can definitely help simplify the process.
Another consideration is that the W-4 form adjusts your withholding assuming that your wage or salary and your deductions and credits are the same over the full tax year. If your salary changes significantly late in the year, or you have changes in deductions or credits, (due to a job change or pay increase, marriage, or having a child, for example) changing your W-4 withholding assumes that those changes happened at the beginning of the year when calculating how much to withhold.
For example, let's say you under-withheld by $1,000 in the prior year and you want to file a new W-4 to correct your withholding for this year. You make the correction and file the new W-4 in April, and your employer implements the change in May. That change will only affect 8 of the 12 months (May-December), so it may only adjust by $667 instead of $1,000. If this was a one-time change, though, you likely will not have to make any changes in the following year.
The Tax Withholding Estimator, on the other hand, is a specific adjustment for the remainder of the current tax year. It asks for the total withholding through the most recent paycheck and specifically adjusts withholding for the rest of the year. In our previous example, if you need to increase your withholding by $1,000 in the current year, this method will achieve that. However, if you do not again change your withholding in the following year your employer will be withholding too much for a full tax year. In these cases, I suggest using the Tax Withholding Estimator every year right after filing taxes to ensure accuracy.
Estimates for Self-Employed or Other Sources of Income
If your primary source of income is self-employment, you likely do not have the option of the automated nature of employer withholding. This means you are responsible for calculating and making quarterly estimated payments to the IRS yourself. You can use form 1040-ES to figure and pay estimated tax. This form basically walks through the process of the next year's tax return and then calculates the minimum amount that needs to be paid to avoid a penalty. It then splits that amount into four and you are required to make quarterly payments in April, June, September, and the following January. These payments can be made by mailing a check or paying online. You can find online payment options at https://www.irs.gov/payments.
State and Municipal Withholding and Estimates
Most states with an income tax have processes similar to the options listed above that allow you to modify withholding with your employer or make quarterly estimated payments, though in my experience the state process is more complicated and less helpful than the federal process. However, the tax amounts are lower, and thus the stakes are lower.
If you live in a state with separate municipal taxation like I do, those cities or other local governments typically mirror these processes as well. At least in Ohio, though, the employer withholding is a simpler process since there is typically a flat tax rate with no deductions or credits. Estimated payments, similarly, are easier to calculate.
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