How to Adjust Your Tax Withholding

Are you tired of handing over too much of your hard-earned money to the tax authorities each year just to get it back come tax time? Or wondering if there's a better way to go about managing your cash flow when it comes to paying your taxes? If so, it's time to take control of your finances and maximize your wealth-building machine. In this episode, I’ll show you how to think about adjusting your tax withholding to keep more money in your pocket throughout the year so that you can have a plan to make that money work for you and not the IRS.

Hello, everyone, and welcome to the Retired-ish podcast. My name is Cameron Valadez, certified financial planner and enrolled agent admitted to practice before the IRS. Today's episode is an incredibly hot topic right now, given that tax payments have been made in April and most refunds have already been issued. This is just such a major pain point for so many Americans. And I'm talking about tax withholding and making sure you're paying the right amount of taxes throughout the year as you earn or generate income, which is what the IRS requires. They have us kind of on a pay as you go system.

In my professional practice alone, my team has noticed a significant uptrend this year in new clients needing and wanting to update their withholding for one reason or another, which I will go over throughout the episode. This is one of those tedious areas of tax planning for most people. Since the process of making changes per your unique situation isn't very straightforward, there are many ways you could go about it, and in addition, oftentimes, it's not something that your tax preparer is going to hound you on throughout the year. Most preparers won't make these adjustments for you either unless you specifically ask them to since their main focus is simply to prepare your return, and that’s even if you have a tax preparer.

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And for those of you preparing taxes on your own, you might find this as one of your major pain points and may find it hard to get right. Understanding how tax withholding works is absolutely key to optimizing your financial situation and, more specifically, your ongoing cash flow throughout the year. So, by strategically adjusting your withholding, you can avoid overpaying taxes throughout the year and getting large refunds in the following year and instead use that money to your advantage to help you optimize your wealth building. In addition, you can avoid underpaying your tax liability and mitigating or eliminating entirely potential penalties for doing so.
Whether you're a retiree receiving various sources of income, you're a small business owner, a freelancer, or simply an individual looking to improve your financial well-being, I've got you covered today. As we go along, I will delve into the intricacies of tax withholding concepts, strategies, some tips, and rules to help you figure out how to better your situation. So, let's get to it.

Okay, so first, we need to understand the basics of tax withholding. When referring to tax withholding, I'm referring to income taxes only. Income taxes are what you owe the federal government or the IRS, and possibly your state, if your state imposes an income tax. There are some that don't. For the purposes of this episode, I'm not referring to what are called payroll taxes, and those are Social Security and Medicare unless you're self-employed, which I will get a little bit more into later. Income tax withholding is the amount of money that is automatically deducted from your paycheck by the institution from which you are being paid. So, this might be your employer if you get a W2 each year.

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It might be a pension, withdrawals from retirement accounts, or possibly Social Security benefits. And when you look at your pay stubs, you'll see federal income tax withholding and possibly state income tax withholding listed on there. These amounts are withheld throughout the year to cover your anticipated tax liability by year-end. It's essentially a prepayment of your income taxes throughout the year as you earn income. The amount withheld depends on various factors, such as your total household income and your filing status when you file your return. Right? Is it single-married filing or joint-married filing separately? You name it.

The potential deductions also impact your withholding and, the credits that you might get when you go to file your return and any additional withholdings that you might have requested. There are many income sources where there actually is no way to automatically withhold and pay taxes as you go. You might be familiar with this if you are self employed or if you have income from rental properties, or maybe you live off of dividends or interest from sources like stocks and bonds in a brokerage account.

You might even receive payments from a note or an installment sale of some sort. In situations like this, the tax authorities still expect you to pay as you go, so you'll need to handle that in a different manner. Next, I want you to understand why adjusting your tax withholdings is so important. It's important because it allows you to have more control over your cash flow each month or every two weeks, however often that you're paid.

And when you overpay your taxes throughout the year, you essentially give the government a loan, and you're giving up the ability to use your own money, whether you would have spent it or saved it. By adjusting your withholding appropriately, you can keep more money in your pocket throughout the year if you've been overpaying, and that can allow you to use that extra cash flow for other purposes, such as building up your emergency fund or paying off debt, investing or saving for future goals or any planned expenses that you have. Sure. Even if you overpay throughout the year, you can still, of course, use your refund that you would get come tax time for some of those same goals. However, due to the time value of money, you will still be losing out on potential growth that money might have provided or even just to ease the burden of paying monthly bills throughout the year.

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Right? It's easier when you have a little bit more of a cushion. That being said, overpaying and receiving large refunds come tax time is not ideal. Receiving a refund is not an indication that you have a fantastic tax situation or have done really good planning. The most basic way to put this concept into perspective is by understanding what is called, what I mentioned, time value of money.

This principle essentially means that a dollar today is worth more than a dollar in the future. And this is true because a dollar today can be invested or put to work in some way to produce a potential return and be worth more in the future. For instance, if you’re used to getting a large refund every year, or maybe your situation has changed this year and you think you're going to get a refund, you might adjust your withholdings so that you begin to take home more money each pay period and then give that money a job. Use that money to maybe pay down interest bearing debt like a credit card or something like that. In this case, the more frequently you make these extra payments towards the principal balance, the smaller your balance becomes, and the less you will be charged in interest moving forward.

This is opposed to instead waiting all year for that large refund come tax time, getting charged interest on that higher balance throughout that time period, and then paying it down in a big lump sum. On the other hand, you might use it to build up your emergency fund if you don't have one, or maybe to build it a little bit larger. This can allow you to go back and review other parts of your financial puzzle, such as your auto policies, your homeowner's insurance, and things like that. And what you can do is consider increasing your deductibles on those policies if you have a very low deductible.

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Now, when you do this, it can typically result in lower ongoing monthly premiums and, therefore, can free up even more cash flow for you on a monthly basis. Then obviously you can invest the money. And as you likely know, there are numerous benefits to this. Over time, to help you build wealth, you can start socking it away for, you know, a nice vacation that you wanted to go on or some other planned expense that you had. But if not, maybe you want to allocate it to, you know, your retirement account. Or, if you don't have a Roth IRA, you can start one of those.

If you do contribute to something like a 401(k), maybe you decide to allocate these dollars to the 401(k) as long as you're not already maxing it out. And in that case, what would happen is if it's a pre-tax 401(k), you would be reducing your taxable income even more, which also might cause you to owe the IRS even less or the state authorities even less money. And then you would have more money that you're bringing home. On top of that, you would have to adjust your withholdings even more.

So all of this stuff is related. It all kind of comes together. It's this endless cycle. Everything affects something else, and you want to figure out how to master your situation. Regardless of what you do, you need to have a set plan for that money that you start to bring home.

Without one, it will likely end up being another one of those black hole expenditures that we all have. Knowing what job to give the money first, then second, and so on and so forth is the art of personal financial planning. Now, the other major reason adjusting your withholdings is so important is to avoid substantially underpaying the tax authorities. So we were talking about overpaying before and receiving a refund. Now, we're on the other side of the spectrum.

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We're talking about underpaying. Underpaying throughout the year via your withholdings being too low can cause penalties, which are essentially more taxes. You may be assessed penalties even if you are due to receive a refund come tax time. Kind of crazy, huh? And to make matters worse, not only are you charged interest on the taxes that are not paid on time, but the IRS and even some states also charge interest on any accrued penalties and interest themselves.

Now, the good news is that avoiding penalties is something you can control when it comes to your tax situation, and that keeps more money in your pocket. So why not make sure that you have control as if you aren't already squirming about paying interest on your accumulated interest and penalties? Here's the kicker. The current interest rates the IRS is imposing are 8% compounded daily. That's surely more than your cash is earning in the bank. Multiples on multiples higher, actually, and still far more than what your cash might be earning in things like your high yield savings account online or the CD that you just bought at the bank.

And lastly, just so you're aware, there are certain criteria that you might meet that don't call for any underpayment penalties to be owed, but that is beyond the scope of this episode. Definitely reach out to your tax professional if you're concerned about owing penalties or have been paying them, you know, frequently in the past. Okay, now let's review some of the different factors that you'll want to consider when adjusting your withholdings.

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First and foremost, you need to have a clear understanding of your current financial situation or your financial puzzle, as I like to call it. Take a look at your income and your expenses on your most recent tax return. Look at any deductions or credits that you've been taking or might be eligible for in the near future. This will give you a better idea of how much your tax liability might be by year-end and, therefore, help you get in the ballpark of what you should be withholding to ensure you're not significantly underpaying or overpaying your taxes. When looking at your income, you'll need to be mindful of what is taxable and what isn't.

If you're still working, there may be part of your pay that isn't currently taxed. Some examples might be certain fringe benefits or contributions to a retirement account. That's usually the biggest one, such as a 401(k) plan, maybe a 403B or 457 plan, or something of that nature. Your tax withholdings should be reflective of your taxable income, so not your gross income, so you wouldn't include these pre-tax deductions in your income when determining what your withholding should be. If you're married, you'll also want to know and understand what your spouse is withholding from their pay.

Additionally, you'll want to consider any changes that may have occurred in your life currently that could impact your tax liability this year and or next year. For example, have you recently gotten married or divorced? Did you have a child do you now have a dependent grandchild? Did you start a new job or receive a significant raise in the middle of the year? Are you expecting a bonus later in the year? If you are going to retire are you going to be receiving any lump sum payments at retirement that are taxable? Are you continuing to work? But maybe your spouse is retiring, right? Or maybe you're retiring, but your spouse is continuing to work.

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Did your spouse pass away during the year? Did you start a small business or a side hustle? These types of life changes will very likely affect your tax situation, sometimes significantly, and it's important to adjust your withholding accordingly to avoid any surprises when it comes time to file your taxes and to be sure you are being efficient with your wealth-building endeavors. If you're going to experience any of these types of changes throughout your life, you'll want to understand where to start when adjusting your withholdings. For instance, if you are going to retire with a pension, you will go from receiving a W2 to a 1099 tax form.

This might also mean that you have to fill out what is called a form W4P for pensions and annuity payments. Don't assume that the withholdings that you put on your old, what we call form W4 when you are working will just carry over to your pension and that they'll be accurate given your new circumstances. You will likely need to adjust them since, oftentimes, the amount you receive in a pension won't be the same as you received while working. In addition, you won't have some of those pre-tax deductions that I just talked about on your pension pay stubs for things like a retirement plan. So, this may change your tax situation as well.

Another common situation to be ready for is when you start receiving Social Security benefits. Although not mandatory, you can choose to withhold from your Social Security benefits. A lot of people get tripped up by this because they assume it will be taken care of for them, and it's actually quite the opposite. The Social Security Administration will not help you determine any withholdings and won't make you withhold. They don't give tax advice.

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Most people find out after their first year of benefits, and they are shocked to see their tax bill. Don't let that be you. The Social Security Administration has a special form to set up your withholdings called the W4V, which I will provide a link for you in the show notes. Other not-so-obvious situations that you'll want to be aware of are instances where you might be the beneficiary of a sizable inheritance. And when you receive that inheritance, you turn around and invest the cash, or you know, if it's property, you can continue to rent that out.

Depending on how you invest this inheritance or this money, you may end up earning, like I said, rent or interest or dividends that will be taxable each and every year. Now, you may need to account for this income and pay taxes on it through what are called estimated payments. And like I said, this would be the same. You know, even if you're earning dividends and interest in a trust or a brokerage account, it's the same as, you know, inheriting an investment property and renting it out and receiving those rents.

If you inherit things like retirement accounts, you will likely be subject to required annual distributions, actually called RMD's required minimum distributions. And you may need to make sure that you withhold the proper amounts on each of those distributions. Lastly, if you start a business, you will want to work with a professional to help you get an idea of the kind of profit you might turn out and whether or not you need to make estimated payments. This is especially true if you also have other income sources in addition to any potential business profits. So if your spouse is working or maybe your small business is kind of a side hustle, and you have another job where you get a regular W2.

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Okay, so how exactly do you determine the correct amount of tax withholding or estimated payments if they're required? Now, I just want to start by saying that actually calculating and adjusting your tax withholding, especially on the different required forms, can be a bit tricky and also very time-consuming, especially if you're going down this rabbit hole for the first time. Estimated payments, on the other hand, are a little more straightforward. The current forms used to adjust your withholdings from something like a paycheck, a pension, or Social Security can be confusing to many people because there's a lot of tax jargon used on the forms and the lack of detail when it comes to some of the boxes you have to check on the forms, in my opinion, these forms, even though they've gone through some changes recently, they're still pretty lousy, and I think they need to be updated to be even more user friendly.

But until that day comes, if it ever does, we are stuck with what we've got. The good news is that there are several resources available to help you navigate the process and do some of the calculations based on your own particular situation. The IRS actually provides a withholding calculator on their website that can assist you in determining the appropriate amount to withhold from your paycheck. This calculator takes into account your income, your deductions and credits to give you an estimate of your tax liability for the year.

It's not going to be exact, so don't expect it to be. The calculator is meant to help you fill out the common W4 forms to provide to your employer or the institution that is paying you. The calculator is not for choosing what to withhold from things like retirement account distributions. In order to calculate this, you will need to have a decent estimate of what your current year's tax liability might look like and how that might change depending on the size of the distributions that you make and when you will be making them. I will include a link to this in the episode show notes the calculator.

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However, I will say after helping countless people with their withholdings over the years, I still hesitate to go off this calculator because it's very time-consuming and most professionals have more sophisticated methods and software that are better, in my opinion. But if you're going at it alone, it can still help you significantly. And as I said before, you might choose to instead consult with a tax professional or a properly licensed financial advisor who can provide personalized guidance based on your specific financial situation. They can help you with the initial heavy lifting when it comes to analyzing your income and how much of your income is actually taxable, your expenses, potential credits, and deductions that you might be taking, taking into account any major life changes and how that's going to affect you and all the other relevant factors we just discussed. And they'll help you determine that optimal withholding or estimated payment amount, and how to actually submit those payments. They can also help you develop a good strategy for what to do with any potential additional monthly income that you might take home as a result, like we talked about earlier.

All right, so all that being said, adjusting your tax withholding is a relatively straightforward process, but that doesn't mean that it's necessarily that easy. If you're still working, the first step is to complete a new form W4, which is the employee's withholding certificate. This form is provided to you by your employer, typically, but you can actually find it online as well, and it allows you to update your withholding information and remember that it goes back to your employer, not the IRS, even though the form itself is an IRS form. This is a common misconception that many people have, and on the form you'll need to provide your personal information, such as your name, address, social, as well as your filing status.

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And at the end of the form itself, there are also detailed instructions on how to fill the rest of it out. Now, if you're receiving a pension, it's a similar process, but you will typically use form W4P instead. As I mentioned before, again, Social Security and even unemployment compensation withholding is done with form W4V. The W4V only allows certain percentages to be withheld, which currently are 7%, 10%, 12%, and 22%, or you can have them stop withholding entirely if you already were withholding.

While the W4V form is simpler to understand and fill out, it is actually less flexible depending on your situation, especially if you're in one of the higher tax brackets. The W4 will essentially calculate a withholding amount based on your filing status and certain deductions in credits you'll be claiming on your tax return. So, it's essentially an estimate. It's not like that W4V where you can just choose a percentage. It actually doesn't have that on there. There's much more to it.

Although calculating the withholdings is so specific to each person's unique circumstances, there are a couple of tips that I can give you regarding the W4 form, which you might find helpful. The first tip is that if you are finding yourself with a big tax liability each year, meaning you are underpaying and it's a fairly consistent amount, you might consider using the section on the W4 titled extra withholding and simply listing the additional dollar amount you want withheld each paycheck or each pay period. This is opposed to going through the other methods on the form, which may prove to be a little bit more complicated and time-consuming, or updating your W4 and also your spouse's W4. This might be the easier route to go.

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In order to do this, you'll again want to have a good idea or at least a projection of the extra amount you'll owe, given your tax situation this year. You can get an idea of this from your tax professional or by doing your own projection if you do your taxes yourself. Now, the second tip I want to give you is kind of the opposite. This is on the flip side. If you need to reduce your withholdings by a specific dollar amount because you get fairly consistent refunds each year, it's a little bit trickier on the form.

There is no line that specifically asks you what you want to reduce your withholding by. However, one option on the form is to use line number three currently, and this is in 2024, where it asks you to put in the amount of any tax credits that you might expect to receive. Although you may not actually be expecting any specific tax credits, any amount put here will reduce your withholdings dollar for dollar as if it were a tax credit. And as a reminder, actual tax credits reduce your tax liability dollar for dollar. So, this is why this method works.

It's basically a workaround. The key detail to note here is that the amount you put on this line is an annual number, not per pay period or per paycheck, like the extra withholding line that I just talked about. So you'll want to do the math on how many pay periods are remaining for the current year and then kind of back into that number. Tip number three. If you would rather not deal with the W4 at all, you can also choose to make what are called estimated quarterly tax payments.

When choosing to make estimates, they are due by certain dates each quarter throughout the year. And if you live in a state that imposes state income taxes, they may have different estimated payment rules as well that you'll want to be mindful of. When making an estimated payment, you can either mail your payment in with what is called a voucher, and the technical title of it is a 1040ES, or make the payment directly online, which is much easier, in my opinion.

Another tip for you is that if you do choose to do things old school and mail in your payments, I find it helpful to add a dollar for each quarterly payment that reflects the quarter that payment is for. So, as a hypothetical example, if you have determined that you need to make roughly $1,000 per quarter estimate payments, you might choose to make the first quarter payment of $1,001, the second would be $1,002, 1,003 for the third quarter, and 1,004 for the fourth quarter.

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This is so that in the case that a check gets lost in the mail or what have you, you can go back to your bank statements and see which payment got lost or undeposited. In order to fill out the estimated payment form or the vouchers with accuracy, you'll want to have your previous year's tax return ready to go and a good idea of what the current year might look like. Now, I will include some additional resources in the show notes for estimated payments, so be sure to check that out. And these estimated payments are paid straight from your own bank account and you can pay whatever makes sense for your situation. There are no complicated formulas and things like that. The difference is that they are not automatic, so you'll need to be sure to remind yourself each quarter to make them throughout the year.

Okay, tip number four while it's not required, I typically like to take the approach of whatever generates the taxes pays the taxes, so in a perfect world, you would have separate withholding on all of your different sources of income. However, for most people, this isn't often the case. So you'll want to do your best to update your withholding on all sources because if you don't, you'll find yourself with a more complicated situation at the end of the day where you are having more taxes taken from source A to pay the taxes generated from income source B. Then if say, income source A stops or goes away at some point in the future, you need to significantly go back and adjust the others.

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I want to make one last note on tax payments for those of you who are business owners. If you have a business, the structure of your business will determine how you pay the taxes that you owe. Generally speaking, if you are what is called a sole proprietor, even if you're a sole proprietor with an LLC, you will pay your taxes from your personal bank account since the business income will flow through to you at the end of the day. You don't need to make the tax payment from the business account per se. What you will want to be aware of is the fact that you will also be subject to self-employment tax in addition to federal and possibly state income taxes. Now, self-employment tax is essentially your payroll taxes owed to Social Security and Medicare.

And since there is no W4 form, if you're a sole proprietor, you're not getting a W2, you will need to pay both self-employment taxes and your federal and possibly state income taxes via those quarterly estimated payments. And there is not a separate voucher or form for each of those different taxes. You simply make your total payments between the two with each quarterly payment. If, on the other hand, you have one of the other more common business structures, which is an LLC taxed as an S corporation, you will likely receive part of your income as a W2 wage.

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Because of this nuance, you will have a W4 for the wage portion of your income, and you also may need to make estimated payments for the portion that is just profit and is not paid out in a W2. This is regardless of whether or not you take the profits out of your business bank account. In other words, even if you don't take the money out, you are still taxed on it in an S corporation, and the S corporation profit flows through to your personal tax return. So again, you would pay any taxes owed personally, and you don't need to pay them from the business bank account. If you did or you have been paying your taxes generated by your S corporation from the corporation's bank account, you are just making your bookkeeper's job a bit more complicated.

All right, now let's talk about exemption from tax withholding. While most people need to have some sort of tax withholding, there are situations where you might be exempt. Therefore, one possible mistake you will want to avoid making is withholding when you actually have an exemption from withholding in the first place. Under certain circumstances, you may be able to claim an exemption from withholding, and if you do so, your employer will not withhold federal income tax from your wages. Again, the exemption applies only to income tax, not to payroll taxes like Social Security or Medicare.

Generally, you can claim exemption from withholding if both of the following circumstances apply to you. The first is that you had a right to a refund of all federal income tax withheld because you had no tax liability in the previous year, and you expect a refund of all federal income tax withheld because you expect to have no tax liability for the current year. And remember, you need to meet both of these circumstances. If you determine that you qualify to be exempt, you must give your employer a form W4 filled out appropriately. This is again that common form that people use to tell their employer what to do when they run payroll on your behalf.

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In situations like this, if the IRS determines that you do not have enough withholding, the IRS will notify you to increase the amount of tax withholding by issuing what is called a lock-in letter specifying the withholding arrangement permitted for you. So this would be like if you think you are exempt, and so you have your employer stop withholding, but the IRS looks through the numbers, and they basically say, hey, nope, you're not exempt, you do have to withhold something. They might send a letter like this.

You can then send in an updated W4 to your employer to self-correct this issue. If you don't correct it, the IRS will force your employer to start withholding more. It's important to note that an exemption from withholding is only valid for one year at a time. You will need to provide your employer with a new W4 form each year to continue that exemption.

Now, here's another quick planning tip for you. Note that you are also required to complete and file a new form W4 with your employer within ten days if you were claiming to be married and you become divorced during the year, or any life event occurs that will decrease the number of withholding, basically allowances that you claim. This can happen if you were once able to claim one of your kids as a dependent on your return and maybe now you're no longer able to. This typically happens once they graduate college or start providing most of their own support. As you have learned by now, adjusting your tax withholding is a powerful tool that can help you take control of your finances by maximizing your take-home pay, which makes it easier for you to piece together the rest of your financial puzzle.

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Once you have a better understanding of the taxes you'll pay, you can start allocating more dollars to other financial goals with much more confidence. By strategically managing your withholding moving forward, you can avoid overpaying taxes throughout the year and instead use that money to your advantage. Whether you're a small business owner wanting to put more money back into your business for growth opportunities or simply an individual looking to improve your financial well-being or investing prowess, you can use it to pay off high-interest debt, invest in your retirement or other shorter-term financial goals, or simply to build up your emergency fund. The choice is yours, but the key is to make sure that you're using that money wisely to maximize your financial growth and complement your financial plan. Withholding is one of those things that is largely in our control and can help significantly when it comes to the mental stress and burden that taxes can often cause.

By figuring out your withholding situation, there's no more wondering whether or not you'll have enough to pay your taxes come tax time by possibly having to go backward and drain your savings account or selling off financial assets that were once working for you. It can also help you save money in potential penalties and interest, of course. Make it a habit to review your income, your expenses, and any life changes that may impact your tax liability at least once a year. This will help you determine if any adjustments need to be made.
Additionally, it's a good idea to review your withholdings whenever you experience a significant change in your financial situation, such as starting a new job or retirement or maybe a change in your spouse's lifestyle. So take charge of your finances today and start maximizing your financial growth through smart tax withholding adjustments.

That about sums up today's episode. If you have questions about tax withholding or estimated payments, send in your questions and I will answer them anonymously on a future episode.

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If you have a question that you want answered, you can use the link in the episode show notes to email it in, or you can voice record it straight from your mobile device. Again, I make it really easy on you guys. You can find a link to do that also located in the episode show notes right there on your device. Don't forget to sign up for the Retired-ish newsletter as well to get your free retirement planning quick guides for 2024. This is useful and easy-to-digest information on retirement planning, investments, and taxes. You get it once a month straight to your inbox. No spam.

As always, if you find the information on this show actionable and insightful, please do yourself a favor and subscribe to or follow the show on your podcast app and share it with a friend who you think might benefit. They don't teach this type of stuff in school, so the more you and your friends and family know, the better off everyone will be.

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Thanks again for tuning in and following along, see you next time on Retired-ish.

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