We all know that federal income taxes are withheld from our paychecks. But are you aware of the degree of control you have over how much is withheld? Here, we’ll discuss the importance of having an accurate W-4 holding, including how recent changes to the tax code present a unique situation for taxpayers in 2018.
Let’s start with how the W-4 actually works. In a nutshell, your employer adjusts your gross pay and calculates how much federal income tax to withhold from your paycheck based on the withholding allowances you claim on Internal Revenue Service (IRS) Form W-4 (Employee’s Withholding Allowance Certificate). Each allowance you claim exempts a portion of your income from federal tax withholding and thereby increases what you receive in your paycheck. So, if you claim too many allowances, not enough tax will be withheld from your paycheck, and you will owe the IRS come April 15. If you claim too few allowances? An unnecessarily high amount of tax will be withheld from your paycheck, and you will get a tax refund.
Of course, no one wants to get hit with a large tax bill. But getting a tax refund is not necessarily a better option. It simply means you have paid more than your share in federal income tax and essentially have given the federal government an interest-free loan.
To use a fairy tale analogy, you want to find a "Goldilocks Zone" where your withholding rate is neither too much nor too little but "just right": maximizing income received in each paycheck without owing additional taxes when you file.
Time to check your W-4 withholding: The Tax Cuts and Jobs Act (TCJA)
Best practice is to review your W-4 annually. Further, it is especially important to check when you experience a major life event, such as marriage, birth or adoption of a child, a spouse getting or losing a job, or a significant pay raise or pay cut. Each of these events can directly affect the amount of tax you will owe. This year presents a unique situation, however, because the implementation of the TCJA means that everyone’s tax situation has changed in 2018.
There are seven new income tax brackets: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. With these new brackets in place, many people making the same income in 2018 that they did in 2017 will find themselves in a lower tax bracket. As a result, many are taking home more money in their paychecks in 2018 compared with 2017.
The TCJA also increased standard deductions across the board:
- For single individuals or for married couples filing separately, the standard deduction increased from $6,350 to $12,000.
- For heads of household, the standard deduction rose from $9,350 to $18,000.
- For married couples filing jointly, the standard deduction went from $12,700 to $24,000.
In addition, the TCJA eliminated miscellaneous itemized deductions and limits state and local income and property tax deductions to $10,000.
So, what does this mean to you? The amount you will owe in federal income tax, the deductions you will be able to take, and the amount that should be withheld from your paycheck have all likely changed.
Finding the “sweet spot”
The simplest and most accurate way to determine your appropriate W-4 withholding election is to use the IRS Withholding Calculator, available on the IRS’s website. Keep in mind that this calculator is designed for most taxpayers, but people with especially complex tax situations may need to reference Publication 505 (Tax Withholding and Estimated Tax).
The calculator will ask for your filing status, your family situation, your income, your current withholding, and other information that could affect your 2018 taxes. To expedite the process and ensure the most accurate result, be sure to have your most recent pay stubs, the previous year’s income tax return, and a copy of your completed Form 1040 on hand before using the calculator.
If the calculator recommends adjusting your withholding, there’s no need to wait! You can adjust your W-4 withholding with your employer at any time, and the change will be reflected in your future paychecks. One important note here: If the calculator recommends a change to your withholding for 2018, be sure to check back at the start of 2019. Why? The calculator is designed to adjust your withholdings so that you pay the correct amount of federal income tax for the current year, based on the information you provide. A midyear withholding change in 2018 may have a different full-year impact in 2019.
Want to learn more?
Of course, this is a general discussion of ensuring accurate W-4 withholdings. If you have additional questions or would like more in-depth information about your withholding, be sure to consult your employer or tax advisor.
Dan Flanagan is a financial advisor located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or at [email protected]
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