You get a Hobson’s choice with taxes: You can prepay or you can prepay.
Although the government insists you prepay what you owe in tax, the IRS generously provides two methods for doing it: withholding and estimating. Your problem is how to be sure you’re paying the right amounts.
Withholding makes your life easier, even if you’d rather not have to share your earnings with Uncle Sam. The IRS doesn’t set the amount that’s withheld from your salary or wages. Your employer determines your withholding from the information you provide on IRS Form W-4. You fill out a W-4 whenever you begin a new job, and you can update an existing one at any time to increase or decrease the amount that’s being taken out.
Sound easy? On the surface, it is. But there’s a catch. What you’re trying to do is to come as close as you can to matching the amount withheld with what you’ll owe in taxes. That way you avoid the prospect of a penalty for underpaying and the pointlessness of overpaying.
Virtually the only wiggle room you have is in the number of allowances you claim—typically one for yourself, one for each dependent you can claim on your tax return, and one for each factor that reduces the tax you owe. The higher the number of allowances, the less will be withheld from your paycheck, and the higher your take-home pay will be. Conversely, claiming few or no allowances means your take-home pay will be lower but you’ll prepay more. If your tax situation is pretty simple—for example, if you have just one job and no investment income—you may be right on target by taking one allowance for yourself and one for each dependent. But if you discover in April, when you file your return, that way too much or too little has been withheld, you need to make some changes to your W-4.
HELP OR HINDRANCE?
To help you figure out the right number of allowances, the IRS provides a “Deductions and Adjustments Worksheet.” It’s about as difficult a document as you’ll find anywhere. To use it, you need detailed information about your income, your expenses, your filing status, and any potential adjustments to income.
Don’t hesitate to ask for help, either from your employer or a tax adviser. But be prepared to share last year’s tax return with the person who’s helping you. And ask for an explanation of any solution that’s suggested so you’ll know how to tackle the problem the next time it comes up.
STAY UNDER THE RADAR
There’s no law limiting the number of allowances you can claim, so you’re free to claim the number that produces the result you seek— coming as close as you can to what you owe.
There may be times when you want to bump up the number of allowances you claim for a short period. For example, if you belong to a union that’s still negotiating a new contract after the old one expires, you may get a lump sum retroactive payment in one paycheck. If your employer were to withhold based on the gross amount of that check, more is likely to be withheld than you’ll owe. So you’d want to withhold less on that payment.
Once that lump sum has been paid, you can go back to the number that more accurately reflects your tax situation.
PAYING ESTIMATED TAXES
If you’re self-employed or a freelancer, either full-time or in addition to working as an employee, the IRS expects you to estimate how much tax you’ll owe for the year and pay part of it each quarter, in April, June, September, and January. You use Form 1040ES, “Estimated Tax for Individuals,” to figure your estimated tax and make your payments.
The first payment is due for the first quarter in which you have taxable income. You can pay everything you expect to owe then, in a lump sum, or you can spread what you owe over the rest of the year. The usual way is to divide the total you’re prepaying by four (or however many quarters are left) and pay it in equal amounts. That’s fine if your income is fairly regular and predictable. But you may have a problem if it’s not—something that’s fairly common when you work for yourself.
The solution may be to recalculate the tax you owe each quarter to find the minimum due on each of the remaining dates. You can get IRS Publication 505, “Tax Withholding and Estimated Tax,” or you can consult a tax adviser. In fact, you may want to find one who specializes in clients with self-employment income.
If you’re paying estimated income taxes, perhaps because you’re a freelancer or self-employed, you have to pay Social Security and Medicare taxes, called self-employment taxes, yourself. The Social Security that’s due in most years is 12.4% of your earnings up to the annual cap. You must also pay 2.9% of your total earnings for Medicare, with no cap.
Those are twice the percentages that your employer withholds if you have a job. That’s because you’re paying two shares—yours as employee and yours as employer. The consolation is that you can deduct half the total, equal to the employer’s share, as an adjustment to income on your tax return. That reduces your AGI, and your taxable income.