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Tax Withholdings and Savings Questions, Answered
Looking at your pay stub and seeing how much money is being withheld from your paycheck can be confusing and frustrating. You worked to earn a certain amount of money, then that pay is nickeled and dimed until your actual paycheck is much smaller.
But how do tax withholdings actually work and where is that money going?
What are tax withholdings and tax deductions?
On many paycheck stubs, you’ll find a number of items that represent money taken out of your paycheck. These tend to fall into two categories: withholdings and deductions.
Withholdings are taken out of your paycheck to cover the amount of income tax and other federal and state taxes you owe. This includes money taken out for Social Security, Medicare, federal income tax and state income tax.
Deductions are taken out for your portion of workplace benefits and charitable contributions. For example, you may have a deduction to pay for part of your health insurance plan or for your 401(k) contribution.
You start out with your gross pay, then your withholdings and deductions are subtracted from that until you’re left with your net pay, which is how much you actually bring home.
Who determines federal withholding tax?
For federal income taxes, Social Security and Medicare, your employer has to follow a formula supplied by the IRS to determine how much to withhold for taxes from your paycheck. For state income taxes, your employer is provided a formula by the state.
In general, the formula for how much to withhold for Social Security and Medicare is pretty precise. However, with income taxes, it’s hard to be quite so precise because the amount of taxes you owe on your income varies depending on how much you earn as well as how many tax deductions you can claim when you file.
[ Next: Here’s How 2021 Tax Brackets Work ]
For example, if you have a lot of tax deductions, you’ll end up owing less taxes, which means that there’s more taken out of your check than necessary. You’ll get that money back as a refund after you file your taxes early next year.
If you have another job, however, you may end up not having enough withheld from your paycheck and may end up being very close to even when you file your taxes, or even paying a bit.
The formulas err on the side of taking out a little more than necessary, as it’s better for most people to receive a refund in April than to have to suddenly pay an extra tax bill, but the formulas aren’t perfect for all situations.
What’s the importance of the W-4 form?
One big part of the income tax formula comes from the information you have given to your employer when you started your job. On the first day at most jobs, you must fill out a W-4 form, also known as an Employee’s Withholding Certificate. It looks like this.
That certificate tells your employer how many people are dependent upon your income, which affects how much tax you pay. These are called “allowances.”
You can claim one allowance for yourself, as long as no one else is claiming you as a dependent. You can claim one allowance for every dependent who is not you or your spouse (usually, this means children). You can claim either zero or one allowance for your spouse. You can also claim one more allowance if you file your taxes as the “head of household” (meaning you’re unmarried and paid more than half the cost of maintaining your home this year).
The more allowances you claim on your W-4, the less money will be taken out of your pay for federal and state income taxes.
You’re allowed to say whatever you want on your W-4 form. All it changes is how much is withheld for taxes from your paycheck. If you put the allowance number lower than your actual allowances, they’ll withhold more from each paycheck and you’ll have a big refund. If you put the allowance number too high, they’ll withhold less from your check, but you’re likely to actually owe money when you file your taxes, which can be a risky proposition for most Americans.
In general, the best move is to be as honest as possible on your W-4 form.
Why shouldn’t I put a high number of allowances on my W-4?
One plan that many people consider is simply putting down a high number of allowances on their W-4 so that their employer takes very little out of their paycheck for income taxes. This means that the paychecks they receive throughout the year are a little bigger, but they’ll have to pay an income tax bill the following April. Some try to “guess” how many allowances they can claim to get their tax withholdings lowered while still hopefully covering their full tax bill.
The drawback of this plan is that you’re likely to end up owing money to the IRS out of your pocket next April, and the IRS is serious when you owe them money. 78% of American households live paycheck to paycheck, meaning that an extra tax bill can cause a real financial crisis in most homes. It’s not worth tinkering with these withholdings just to have an extra $20 or $30 in each paycheck because the consequences of not having enough to pay your tax bill next April could be disastrous.
What about a plan in which you simply put some money aside in a savings account each week to pay your tax bill instead of having it be withheld? On paper, this seems like a great idea. You put some money in a savings account each week, it earns interest, then you use that money to pay your tax bill next April and the money remaining in the count is your immediate “tax refund,” plus the interest.
On paper, that seems like a nice plan, but there are some real problems with it.
First, you’re not going to earn a lot of interest this way. With savings accounts mostly paying far less than 1% in annual interest, you’ll earn on the order of $5 for every $1,000 in the account if that $1,000 sits there all year. It’s not a big boon.
If you decide to do something more aggressive with the money, you risk losing some of your investment, leaving you without enough to actually pay your tax bill.
Second, this plan relies on you calculating the right amount to save each week. If you get it wrong, you may end up still owing money next April, or you may end up putting too much in there, which puts you essentially right back where you were before you started tinkering with your W-4 allowances.
Third, you have to be able to completely resist the temptation to touch that money. When the holidays hit, it can be extremely tempting to tap a savings account to buy that “perfect” gift for someone or to fly somewhere for a holiday visit. That would leave you without any money to pay your tax bill when the IRS comes knocking in April.
Those three problems, compared to the small benefit you’d get out of following such a plan, mean that upping your allowances and then trying to save for your taxes yourself isn’t a worthwhile approach. Let your employer do the work, with the IRS formula in hand based on your correct number of allowances, and then you have no worries when it comes to your taxes.
How to save on taxes
Instead of tinkering with your paycheck withholdings, you should instead focus on maximizing your tax deductions and tax credits. Use a good tax software package that can help you identify all deductions and credits you might be eligible for, or rely on a good tax preparer like H&R Block.
You’re going to eventually face a tax bill regardless of what you do, so focus your energies on keeping that tax bill low rather than playing roulette with your paycheck withholdings.
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