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Make this key move now to avoid an 'unpleasant surprise' on Tax Day, experts say

Nearly half (45%) of Americans can't remember the last time they updated their withholding.

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There's a new version of the W-4, the tax document that you use to tell your employer the amount of federal tax you wish to be withheld from your paycheck.

OK, that's actually old news. The IRS debuted the new version of the form around this time last year. But if you're like most Americans, you didn't take much notice. Only about 1 in 4 Americans has updated their withholding since the release of the new W-4, according to a recent survey from the American Institute of Certified Public Accountants. What's more, nearly half (45%) of Americans can't remember the last time they updated their withholding, while nearly 2 in 5 (37%) admit they're unfamiliar with the W-4 altogether.

When it comes to your taxes, ignorance isn't bliss, says Gregory Anton, chairman of the AICPA's National CPA Financial Literacy Commission. Correctly filling out your W-4 is one of the key deciders in whether you get a refund or a tax bill each spring. "Inaccurate withholding can lead to an unpleasant surprise come Tax Day," he says.

To avoid such surprises, check on your withholding sooner rather than later. By making the appropriate adjustments now, you can prepare for a 2020 tax bill and set yourself up for a less stressful 2021 tax season.

Use the IRS Tax Withholding Estimator tool

The IRS recommends that you check the amount you're having withheld any time you experience a big life event such as a marriage, the birth of a child, an adoption, or a home purchase, as such milestones can have a huge impact on your tax situation. The nation's tax collectors also hope that you'll give yourself regular checkups — especially since the IRS occasionally makes major changes of its own.

Early 2018, for instance, saw a major revision to the IRS' withholding recommendations as part of the Tax Cuts and Jobs Act, a tax overhaul that, among other provisions, doubled the standard deduction. Yet only 14% of Americans adjusted their withholding following the revision, which meant many people had smaller-than-anticipated refunds — or even unexpectedly owed money in 2019.

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"In the last few years, folks have been surprised with their refund or amount due," says Joanna Powell, managing director at tax consulting firm CBIZ MHM. "With the IRS calculator, you can see where you'll end up in April, and maybe make a few adjustments so it's not as much of a gut punch."

To see what your tax bill or refund will look like, you'll have to enter information from your most recent paystub, such as your wages, your current federal withholding rate, and whether you contribute to a tax-deferred retirement plan such as a 401(k). After you answer some tax questions, including whether you expect to receive any of several listed tax credits, the calculator will estimate your potential refund or tell you what additional taxes you might have to pay.

To make an adjustment, you'll have to fill out a form W-4 (which comes with worksheets that help you fill it out) and submit it to your employer's payroll department.  

Avoid the shock of a big tax bill

If the amount you've had withheld from your paycheck falls short of what you actually owe on your 2020 income, you'll have to pay the difference to the IRS come Tax Day. Depending on how short you are, you may also owe an underpayment penalty equal to about 3.4% of your underpayment, a percentage that gets reduced the sooner you pay it off before April 15.  

Other sources of income can create a withholding gap. Unemployment benefits are taxed as income on the federal level, for example, but opting in to have tax withheld is a voluntary extra step when you apply for benefits. And 1099 income doesn't have tax withheld, either — you'll typically need to pay quarterly taxes to cover that obligation.

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Finding out you can expect a tax bill early not only gives you time to come up with the money if you don't have it but may also allow you to mitigate some financial damage. If you have another paycheck or two coming in before the end of the year, adjust your withholding now to take a chunk out of what you owe, says Powell.

If you owe more than $1,000 even after applying eligible credits, "it's likely too late to adjust your W-4, and you should pay estimated tax," says Lisa Greene-Lewis, a CPA and editor of the TurboTax Blog. You can calculate and pay your estimated tax via IRS Form 1040-ES.

You probably don't want a big refund either

In theory, finding out that you're owed a juicy refund beats learning that you owe the IRS. But it's wise to keep cash back from the government to a minimum, Melissa Labant, director of tax policy and advocacy at AICPA, previously told Grow. "If you're getting a refund, you're in essence giving the government an interest-free loan," she says.

In other words, rather than sitting in the IRS coffers collecting dust (and earning no interest), the extra money that you're overpaying your taxes with could be in your pocket every month. Or in your bank account. Or invested in your portfolio.

If your calculations indicate that you're in for a big windfall in the spring, it makes financial sense to adjust your withholding for next year so that the amount you have withheld roughly equals the amount you'll owe, says Kim Hardy, a member of AICPA's financial literary commission. "This will allow you to have more money on hand throughout the year that can be better spent staying current on bills, paying down debt, or being invested," she says.

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