Whether workers get a windfall from Uncle Sam or wind up owing taxes mostly comes down to filling out one form correctly – and few people are doing it.
In fact, 45% of the people polled by the American Institute of CPAs said they don’t know when they last reviewed the amount of tax withheld from their paychecks.
The organization surveyed 2,028 adults online from Oct. 1 to Oct. 5.
Close to 4 in 10 were unfamiliar with the key document that can determine whether they’re owing or getting a refund – that’s Form W-4, the AICPA found.
Indeed, the IRS issued 125.3 million refunds for the 2019 year, with recipients getting back an average of $2,535, according to agency data as of Nov. 20.
With 2021 just around the corner, now is the perfect time for financial advisors to nudge clients into reassessing their withholding so that they can start the new year on the right foot.
“People who become familiar with the W-4 have the ability to get their withholding closer to reality,” said Neal Stern, CPA and member of the AICPA’s financial literacy commission. “It would take effect at the start of the year if you do it now.”
The feel-good effect
While it feels good to get a hefty check from the IRS in the spring, it really means that you voluntarily overpaid Uncle Sam in the prior year.
In other words, your withholding was too high and you took home less cash.
Meanwhile, if you wound up owing the taxman, you may have pocketed more money – but you also paid too little in tax over the year.
“There’s this scary psychology around ‘I owe taxes in April’ or ‘I’m getting this refund,'” said certified financial planner Michael Goodman, CPA and founder of Wealthstream Advisors in New York.
“All that happened is the reconciliation of the money you deposited over the year compared to what you owe,” he said. “It comes down to withholding.”
That’s where Form W-4, the employee’s withholding certificate, enters the picture.
Just the right amount of taxes
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Employers use this document alongside the tax withholding tables to figure out how much income tax gets pulled from your paycheck.
The W-4 considers the number of dependents in your home, your filing status – single, married and filing jointly, or head of household – the income you bring in and whether you take the standard deduction or itemize deductions on your tax return.
Key life events warrant updating tax withholding, including getting married or divorced or having a child.
The form is also worth another look if you’re working 9-to-5 while generating side income from other work; it’s easy for new entrepreneurs to fall short of paying quarterly estimated taxes.
Workers will want to team up with their financial professional to get their withholding just right.
The IRS also offers a withholding calculator to give taxpayers an idea of how much of their pay should go toward taxes. To narrow this figure down, you’ll need your latest income tax return and your pay stub.
Workers aren’t the only ones who should tweak their withholding. Retirees can revisit Form W-4V to adjust the income taxes paid from their Social Security, and they can update the taxes withheld from pension and annuity income.
“These people are on a fixed income, and shelling out additional amounts in April could be a bigger shock to the system,” said Goodman.
Know when to call for help
Be aware that the IRS income tax withholding calculator covers what you owe the federal government.
Taxpayers may want to talk to a tax professional to figure out whether they’re properly withheld for state income taxes as well.
This issue is especially important now that many workers have been punching into the office virtually and potentially incurring unexpected state income taxes.
“Some states have an income tax of their own, and you can get a credit for those taxes in the state where you’re domiciled,” said Stern. “But you have to fill out the right paperwork.”