How to Adjust your Tax Withholding

Happy Tax Day

I hope you’ve already finished filing your taxes, but if not you have a few more hours before you will need to file an extension (as on the date this was posted). Either way, while you’re already thinking about your tax refund or taxes due, this is the perfect time to adjust your tax withholding for next year.

How much should you be withholding?

First off, a warning--do NOT use the IRS withholding calculator. This has been famously broken since the tax law change that took effect in 2018 and may have caused many people to receive a surprise tax bill this year as they thought they had adjusted their withholding appropriately.

The easiest way to tell if you’re withholding enough is to go through the full exercise of calculating your taxes for a year (which hopefully just happened) then make small adjustments from there. Assuming there are only minor changes this year you can ask your HR department what your current withholding is. In the current withholding forms, the IRS asks for a number of “allowances.” This is basically the number of dependents in your home. Dependents include you, your spouse, your kids that you get to claim as dependents, and your elderly parents (living in your home who you provide more than 50% support for). However, the number you put on the withholding form (W4) doesn’t actually have to match the number of dependents you have. If you claim more dependents your company will withhold less from each check, and if you claim fewer dependents your company will withhold more from each check. The thought is, if you have more dependents your taxes will be lower because of more credits and deductions.

So, if you need to withhold more you can either specify an amount per paycheck or lower the number of allowances on your W4. If you need to withhold less you can increase the number of allowances on your W4.

There’s got to be a better way!

The IRS is currently proposing changes to the W4. The current proposal will make it a mini-1040 and ask for information about non-wage income, itemized deductions, and tax credits. To fill out the proposed form you will need to refer to 12 other forms and publications, but the form itself is shorter. This proposal has met with so much criticism that instead of rolling it out for 2019 they are currently taking comments with the intent to roll it out for 2020 after making adjustments.

So for now, the best way is to look at your most recent tax return and make small adjustments to withhold the “right” amount.  

How much is the “right” amount of withholding?

Here I’m going to disagree with most of my colleagues. A lot of people will argue that you should aim to withhold enough taxes that you get a $0 refund. That’s pretty hard to do, so some argue you should aim to pay just a little in taxes, while others admit it’s nice to get a refund, but aim to keep it less than $500. Their argument is that you’re giving the U.S. Government an interest-free loan “for 12 months” if you withhold too much.

I believe you should try for a refund of $1,000 - $3,000. Personally, I go for about $2,500. Here’s why:

  • My loan to the government isn’t for 12 months, 1/12th of it is for 14 months, 1/12th is for 13 months, etc. On average I’m loaning them money for roughly 8 months, since the earliest you can usually file your taxes is mid-February.
  • If I received the extra $200 a month I would likely consume the money, not save it. Small increases to your paycheck have a way of slipping away and when you ask yourself where the money went, there’s often no good answer. By having the Government hold onto my money they are forcing me to save.
  • An extra $200 a month isn’t a game changer, but $2,500 once a year can be. When we get our refund we immediately move the money over to our high-interest savings at Ally. Then we allocate part of it for projects around the house and part for longer-term savings like vacations, college, or paying off the mortgage.
  • I’ve been around enough tax returns to know I may have missed something during the year. I’ve seen too many people get a surprise tax bill not to build a little extra cushion just in case.

In short, there is no “right” amount of withholding. Just make sure you are withholding enough not to pay under-withholding penalties. To avoid this you have to pay at least 90% of the tax due for the year through withholding or 100% of the tax you owed the prior year (110% of the tax you owed the prior year if your adjusted gross income was $150,000 or more). For those that needed to read that sentence a few times, it’s the IRS’s wording, not mine...Personally, I’m hoping we don’t have to read 12 pages of IRS speak to fill out a W4.