A Tax Guide To Payroll Withholding

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Employers typically withhold money from employee paychecks and use it to make tax payments to the IRS in each employee's name. However, employees can opt to have additional funds withheld from their paychecks. The theory for additional withholding is that the over-payment in taxes will result in a tax refund check or it will make sure that the employee does not owe a significant amount of money to the IRS when tax season rolls around. Opinions are divided on whether asking your employer to withhold additional funds is a sound financial decision. Here's a look at some of the pros and cons of withholding too much or too little from your paycheck.

Withholding 101

The amount of money withheld from an individual's paycheck is dependent upon a number of factors. These include:

  • Filing status (married filing jointly, married filing separately, single)
  • Number of dependents claimed
  • Head of household status
  • Child care credits and expenses

Employees must supply this information to their employer via an IRS Form W-4, which is used to calculate how much tax should be withheld by the company. Employees can also opt to specify a dollar amount above and beyond the calculated tax estimate that should be withheld from paychecks. This strategy is used by some tax payers in order to get a larger tax refund on April 15 of the following year.

Why Withhold?

To Save Money: Some individuals choose to use withholding as a savings strategy. They believe that withholding additional funds will result in a large refund check that can be used to pay off debt, make large purchases or fund a vacation.

For some tax payers, this is an easy way to save money. Some people have a hard time committing to savings if they have easy access to their funds through a savings account. When additional money is withheld from paychecks, however, there's no way to access it until taxes are filed and a refund is issued.

To Avoid A Large Tax Bill During Tax Season: According to personal tax software maker Intuit, many people also withhold additional funds because they are trying to avoid a tax bill during tax season. If they withhold the right amount of funds for their paycheck, then they will not have to pay a significant tax bill when they file their taxes. In fact, they might even get a refund for overpaying.

The Case Against Withholding

On the other hand, some tax experts say tweaking your withholding amount isn't a wise idea. Essentially, taxpayers that withhold additional funds are giving the federal government an interest-free loan. Even if you've withheld twice as much as you actually owe, you won't receive an additional dime in interest from the IRS when tax time rolls around.

Rather than allow the government to utilize your hard-earned money as an interest-free loan, some financial experts say it's better to have the additional money automatically transferred to a savings or investment account. This way, your money can earn interest throughout the year.

In an article for MSN's Money Central, Jeff Schnepper points out that there's a psychological benefit most people get from knowing they have a big refund check coming from the IRS each year. However, he recommends decreasing withholding to the specific amount you'll owe the IRS each year. This will allow you to earn interest on your money instead of getting it back interest-free from the IRS after tax season.

Extenuating Circumstances

Making the choice to withhold additional funds isn't a cut-and-dry exercise. According to Fairmark.com, some taxpayers have other circumstances that might make it worthwhile to opt for additional withholding. Income from a business, investments, capital gains or stock dividends can change the way you look at your withholding situation.

Each of these circumstances could mean a taxpayer should be making quarterly estimated tax payments to the IRS. If these types of income are supplemented by standard W-2 employment, however, it's possible to choose additional withholding to compensate for other sources of income. This helps taxpayers avoid the hassle of making quarterly estimated payments and it can reduce the likelihood of having to pay a penalty for under-payment.

If using this strategy, Fairmark advises using the additional withholding option to specify a certain dollar amount. Simply increasing allowances is ambiguous in terms of how much it will actually affect the amount withheld. Therefore, taxpayers who know how much investment or business income they will incur throughout the year should specify an accurate amount to withhold that will cover the additional taxes due.

It's always advisable to seek the counsel of an accountant or other tax expert when business income comes into play. There are various ways to handle tax payments in these situations, and a certified public accountant can offer the best advice for each individual's financial situation.

So should you withhold additional funds this year? If you have additional income from a personal business or investment portfolio, additional employer withholding lifts the burden of having to pay quarterly estimated tax payments and can decrease the risk of under-payment penalties. Alternatively, using additional withholding as a forced savings account can be useful for those who have difficulty saving. However, for many people, additional withholding does little more than provide the government with an interest-free loan.

Sources

Last Updated: February 6, 2012
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About Angela Stringfellow Angela Stringfellow is a contributing author to CanDoFinance.com. Angela is a PR and MarComm Consultant and Social Media Strategist offering full-circle marketing solutions to businesses.

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