Am I Withholding Enough Tax?

It’s tax time! Are you expecting to get a refund or write a check to Uncle Sam? If it feels a bit like the lottery to you, here are a few tips to take more control over whether you get a refund or have to write a check next tax season.

Pay as You Go

There are two ways to pay your federal income taxes as you go: withholding and estimated tax payments. You can actually owe a penalty if you don’t pay in enough of your tax bill by one of these methods.

Withholding: This occurs when your employer or other payer holds out income tax from such payments as your salary, tips, pension, unemployment compensation, and gambling winnings.

Estimated tax payments: This is when you make four payments to the U.S. Treasury during the year, if you don’t have enough tax withheld from income you receive. You make the payments to cover the amount you anticipate you’ll owe when you file your return. Typically self-employed individuals use this method to pay income taxes. I recommend that you consult with a competent tax CPA if you are considering making estimated tax payments.

Forced Savings

Many taxpayers use federal income tax withholding as a way to save money. You arrange to withhold more than your anticipated tax bill and enjoy the refund check later. Sounds great, but the IRS is not a bank. You cannot make withdrawals, write checks or receive interest. Okay, so savings account interest is puny these days. But the IRS holds your money for 6 to 18 months and pays you nothing. Even a certificate of deposit will pay you something.

Forced saving using withholding might be good for you if you lack discipline to save. The risk of a refund is that you “save” this money all year only to blow the refund on unnecessary spending. If you are not a saver and you try to minimize your withholding, you may be faced with borrowing from your credit cards to pay taxes owed on your return.

If you are married and both of you are employed, it is sometimes tricky to figure out the right withholding level and the right number of exemptions to select on each of your Form W-4. The W-4 instructions are confusing for two-earner families. If you are a couple who have more than just two jobs, it is even more difficult to find the right mix of withholding and exemptions.

Fringe Benefits can be Taxable

If you receive certain noncash fringe benefits as a part of your regular pay, your employer must withhold tax. Fringe benefits can include club dues, qualified bicycle commuting reimbursement, spouse’s travel expenses, and certain personal use of a company car.

There are two options to withhold tax on fringe benefits. Your employer can withhold tax from the benefits along with your regular pay and at the regular rate. Or your employer can withhold 25% of the benefit’s value. Consult your employer for the option that’s used.

Withholding Can Depend on Kind of Payment

The kind of payment you receive affects the amount of tax that your employer withholds.

Periodic Payments: For these, you fill out a Form W-4P unless you wish your employer to use the default withholding. The default withholding calculation is based on married with three withholding allowances, regardless of whether you are married. You can also opt to have no federal income tax withheld.

Non-Periodic Payments: The payer will withhold a simple 10% of your payment. No need to complete a Form W-4P. But if you want more than 10% withheld, you need to submit that Form W-4P. As with periodic payments, you can opt to have no federal income tax withheld.

Eligible Rollover Distributions: Generally, distributions that are eligible to be rolled over into a qualified retirement or annuity plan will have a 20% withholding. If you are unsure as to whether your plan is a qualified retirement or annuity plan, consult a CPA. If you wish to have no withholding, you need to roll over your distribution directly from your existing plan to your target qualified plan or IRA account. There is no opportunity to simply opt out of withholding if you are not directly rolling the distribution. I guess Uncle Sam doesn’t trust us with large sums of money.

Distributions from Pensions, Annuities and IRAs

Unless you instruct differently, federal income tax will be withheld from pension and annuity distributions. Among other distributions, this includes stock bonus plans, profit-sharing plans, deferred compensation plans and endowments.

For pensions and annuities, a portion of your check is not taxable if you paid into the plan. That portion is the return on your investment. The portion that is not a return on your investment is taxable. See a competent CPA to gain an understanding of how much will be taxable.

Your IRA custodian will withhold federal income tax on your distributions unless you tell them not to. They will generally withhold 10% from your distributions. (A distribution is not a trustee-to-trustee rollover. Taxes are not withheld on those rollovers.) You fill out a Form W-4P if you are receiving payments on a periodic schedule. The tax withheld is based on your marital status and number of withholding allowances that you claim on your Form W-4P

When I selected this topic, I thought I was picking a relatively straightforward assignment. Ha! I could write at least three more columns on the information I did not include in this article. Admittedly, specializing in divorce financial advice, I do not have a tax practice. As I write each column for the Eagle, I am ever more impressed with the complexity of various income tax issues Americans face today. This enhances my existing respect for my CPA peers who specialize in tax. My tip to you, dear readers, is to never, ever assume anything to do with taxes is simple. Keep yourself out of trouble by consulting a Certified Public Accountant.