Ben Franklin was on to something when he wrote, “In this world, nothing can be said to be certain, except death and taxes.” For most working Americans, the reality of taxes hit hard when they get their very first paycheck. “When I was 16, I got a job working at a restaurant,” says Mikel Van Cleve, advice director and CERTIFIED FINANCIAL PLANNERTM professional at USAA. “I’d done the math based on my hourly pay and was surprised — and disappointed — to see the figure on my check!”
That day, Van Cleve received his crash course in tax withholdings, the income tax employers withhold from their employees’ paychecks in order to pay Uncle Sam.
Like every other law-abiding employer, Van Cleve’s based his tax withholdings on the W-4 form Van Cleve completed when he got the job. On the W-4 form, employees report basic identifying information, such as their name, address and Social Security number, as well as their filing status (head of household, single, or married), number of qualifying children and dependents, other non-job-related income, and deductions.
Van Cleve explains why accuracy matters when completing the form: “If you don’t get it right, you run the risk of either overpaying or underpaying the government throughout the year, both of which could have consequences for your budget.”
When you should review your W-4
The start of a new year is a great time to review your W-4, but you should also update it throughout the year as you or your spouse experience personal life changes. Some of the more common reasons to update your W-4 include:
“Reviewing your W-4 now could make a big difference in the total amount your employer withholds for the year,” Van Cleve says. “You want to speak with a tax professional and/or use the available tools on the IRS website as soon as you experience a significant change. This will allow you to update your W-4 in a timely manner and minimize the impact of over or under withholding. You don’t want to be off track for an entire year.”
How is the new W-4 form different?
When the Tax Cuts and Jobs Act (TCJA) became law in 2017, changes to the federal income tax system included removing personal exemptions and increasing the standard deduction. To accommodate those changes, the IRS introduced a new form in 2020.
“The new design reduces the form’s complexity and increases the transparency and accuracy of the withholding system,” the IRS told tax payers. While the new form asks for the same basic information as the previous form, “it replaces complicated worksheets with more straightforward questions.”
For example, whereas the old form asked employees to calculate the appropriate number of withholding allowances, the new form collects more straightforward information that the employer will use to calculate withholding. Additionally, the old W-4 form included detailed instructions and worksheets to help employees report any adjustments to withholdings because of multiple jobs, and the new form has three straightforward options you can choose from.
“Most employees don’t have to update their W-4 form every year, so a lot of folks are still using the old form,” Van Cleve says. “Even if not required, it’s good to be proactive about reviewing it and giving your employer the most up-to-date information.”
How tax planning impacts your budget
When you sit down to create a budget, the first number you need to know is your take-home salary. “That’s another reason why it’s important to get the W-4 right,” explains Van Cleve. “The amount that hits your bank account each pay period determines everything else — how much you have to spend and how much you’re able to save.”
If you “under-withhold” taxes each pay period, you run the risk of planning your purchases and expenses around an amount you don’t really have available. “When tax time comes, you may have to write the IRS a check—in some cases a big check—and not having the funds set aside to cover it.” Even worse, if you under-withhold by too much, you could find yourself with a tax penalty on top of it all.
It may be easier to under-withhold than it seems. “One example might be checking the box that indicates there are only two jobs total, when your spouse actually has a side job as a woodworker,” Van Cleve says. Employers run a calculation and withhold based on the information you provide on your W-4. Depending on the amount of money your spouse made from that side job, you may end up with a much bigger tax bill than you expect.
If you over-withhold, on the other hand, less money hits your bank account each pay period. “That’s money you could have used to help you achieve your financial goals, but instead you’re giving the government an interest-free loan,” Van Cleve says.
For example, let’s say you receive a $3,600 tax refund in 2022 for 2021. That may mean your paycheck was $300 less than it could have been each month.
“Imagine taking $200 of that every month and paying extra on a credit card with an interest rate of 20%. Depending on your current balance, you could save a considerable amount in interest,” says Van Cleve. “Or say you took that $200 and set it aside in an emergency fund. In five months, you could reach the initial goal many set of $1,000 for emergencies. The other $100 you might spend or set aside for a vacation fund or major purchase.”
Van Cleve acknowledges that some people choose to take their lump-sum refund as a form of forced savings and use it to pay off debt and save for retirement. After all, according to the National Retail Federation, paying off debt and saving are the top two ways Americans plan to use their tax refunds. “But all things being equal, the sooner you start paying down debt, the less you’ll pay in interest. And the sooner you start saving, the more you could potentially earn in interest, as well.”
At the end of the day, personal finances are just that — personal — and often come down to human behavior more than dollars and cents.
“For some, the temptation of having extra money each pay period may be too much, and they may end up increasing their spending and consumption instead of adding it to the budget,” says Van Cleve. If that sounds like you, you may want to continue giving the government an interest-free loan and hold out for your refund in 2022. “But if you have the discipline, consider putting more into your pocket each pay period.”
Ready to develop your 2021 tax strategy? Consult your tax professional and/or use the IRS Paycheck Checkup tool to get started.
About Mikel Van Cleve: Mikel Van Cleve is a CERTIFIED FINANCIAL PLANNER™ professional and Advice Director for USAA Bank. A native of Conway, Arkansas, Van Cleve graduated summa cum laude with a bachelor’s degree in finance from Liberty University. He also holds a master’s of business administration from Texas A&M–Corpus Christi.
With more than 17 years of experience in the financial services industry, Van Cleve’s daily focus is on helping families work toward and reach their financial goals. His advice has appeared in national publications from The Wall Street Journal and The Associated Press to CNBC.com and Business Insider. He writes personal finance articles for USAA’s Community and helps lead the USAA Bank advice strategy.
Prior to entering the financial services industry, Van Cleve served in the U.S. Coast Guard. Outside of work, he enjoys spending time with his wife and children and rooting for the Arkansas Razorbacks. Go Hogs!
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