My husband and I were recently shocked by the amount of our income tax refund. At first, we were elated. It was enough to pay off our car, allowing us to live debt-free. At the same time, we were kicking ourselves for not having this money available for use during the past year.
Maybe you’ve had a similar experience — or the opposite (and decidedly less pleasant) one where you’ve had to pay more money in federal income taxes than you expected. Regardless, the issue is the same.
In both these situations, the amount withheld from your paycheck isn’t coinciding with the amount you really owe.
The best way to fix it is to adjust your federal income tax withholdings, which you can do in a few simple steps. But only make such an adjustment if you’re sure you need to.
When to Adjust Your Income Tax Withholding
You can adjust your withholding at any time. However, many life events can impact your taxes, so it’s a good idea to update your withholding whenever something significant changes.
These life events are a red flag you may need to revisit your withholding.
1. You Started a New Job
When you get a new job, your employer requires you to fill out a W-4 so they can determine how much federal income tax to withhold from your paycheck.
It may seem like just another routine part of your onboarding paperwork, but it’s crucial to complete the form accurately to ensure you won’t end up with an unexpected year-end tax bill.
2. You Got a Big Refund
If you received a large tax return from the IRS for last year’s taxes, that means your employer was taking too much money out of your paycheck. It’s exciting to get a big check, but think of it this way:
That’s money that belongs to you that you were essentially loaning the government interest-free. If you didn’t do that, not only could you have used that money throughout the tax year to pay for your expenses, but you could also have invested it and received interest on it.
It’s exciting when you can do something smart with your tax refund, but it is not the best financial situation.
For example, say you got a refund of $1,000. You gave the government $1,000, and the government gave you back $1,000.
Had your tax withholding amount been correct, you could have invested that $1,000 or had it available in an emergency fund instead. Instead, you gave the federal government an interest-free loan.
The IRS will only refund the amount you overpaid, with no interest. So your goal should be to have zero tax refund, or close to it.
3. You Owe Money to the IRS
It’s an awful feeling when you owe a large amount of money to the government, especially if you thought you might be getting a refund. But as with anything you must save up for, you need to put a little extra money aside with each paycheck to cover a considerable expense.
One way to do that is not to have the money in your possession at all. Out of sight, out of mind. Increase your withholding so the government gets the money before you receive it.
For example, if you owe $1,000 and get paid weekly, you can spread that $1,000 out over 52 weeks. So instead of owing the government $1,000 in one lump sum, give them an extra $20 each week to avoid owing when you file your taxes at the end of the year.
4. You’re Expecting Life Changes
When your life changes, so do your taxes.
All these things affect your taxable income and tax breaks like itemizing versus claiming the standard deduction or claiming the child tax credit. So take the opportunity to review your tax withholding and adjust accordingly.
How to Adjust Your Federal Tax Withholding
To adjust the amount of taxes withheld from your paycheck, the first step is on you, and the rest is on your employer. There are a few different methods to determine the withholding that makes the most sense for your tax situation.
Before you get started, have your previous year’s tax documents handy as well as your last pay stub.
1. Form W-4 Employee’s Withholding Certificate
If it’s been a few years since you filled out a Form W-4 for your job, you might think you need to calculate the number of allowances you need to claim to get the right withholding. But allowances aren’t part of Form W-4 anymore.
The Tax Cuts and Jobs Act of 2018 eliminated personal exemptions — a set amount taxpayers could deduct for themselves, their spouse, and each of their dependents
The old allowance method of calculating withholding was tied to those exemptions, so it didn’t make sense to use them anymore, and Form W-4 was redesigned in 2020 to reflect a new way of estimating your tax liability. Now, it includes just a handful of steps to help you complete the worksheet and adjust your withholding.
If you and your spouse are a two-earner household, pay special attention to Step 2, whether you’re going to be married filing jointly or separately, as it has instructions for joint filers that both hold jobs.
If you need more help, the IRS has a more user-friendly tool: a withholding calculator.
2. IRS Withholding Calculator
The easy-to-use IRS Tax Withholding Estimator is on the IRS website. To use it, you answer a series of questions about your filing status, dependents, income, and tax credits. That’s where having your previous tax documents and last pay stub comes in handy.
3. Fill Out a New Form W-4
Once you’ve used the Tax Withholding Estimator tool, you can use the results of the calculator to fill out a new Form W-4. Give it to your employer’s human resources or payroll department, and they’ll make the necessary adjustments.
Some employers have an automated system for submitting withholding adjustments, so check with your employer to see if they have this option available.
It’s a good idea to take action as soon as you know you need to adjust your withholding since it will impact every paycheck you earn for the rest of the year.
The lower your withholding, the less tax your employer will withhold from your paycheck. That may seem like a good thing, but you don’t want to have too much withheld or you could be liable for an underpayment penalty when you file.
Managing taxes can be confusing, and withholding is just the first of many things you need to know to handle your taxes well. For more guidance, check out our complete tax filing guide.