26.4 Are You Withholding the Right Amount?

You do not want to withhold too little from your pay and you do not want to withhold too much. You may need to withhold more to avoid a large tax payment or an estimated tax penalty (26.1) when you file your return, especially if you have substantial income from investments or a business.

Planning Reminder

Part-Year Employees May Avoid Overwithholding

Starting a new job in the middle of a year presents a withholding problem. The amount of tax withheld from your paycheck is figured by taking your weekly pay and multiplying this by a 52-week pay period. For example, if as a recent graduate you start a job on July 1 and your weekly pay is $1,000 for 26 weeks (July 1–December 31), your withholding will be based on an annual income of $52,000 ($1,000 × 52 weeks) and not the $26,000 you will actually earn that year. This will result in overwithholding. To alleviate this problem, you may ask your employer to calculate withholdings on what is known as the “part year” method if your work days during the year are expected to be 245 or fewer. This formula calculates withholding based on actual earnings rather than expected earnings over a full year of employment. As an alternative, you may elect to claim extra exemptions on Form W-4, which has the same effect of reducing the amount withheld each week from your paycheck.

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On the other hand, if you have been receiving large refunds from the IRS, you may want to consider reducing your Form W-4 allowances to avoid over-withholding. Balance the loss of the use of your earnings during the year against the value of receiving a substantial refund check from the IRS after you file your return.

If you are starting a new job or if you have not changed your withholding allowances in several years, review the Form W-4 worksheets to help you determine if you are withholding the right amount.

Working couples filing jointly should figure withholding allowances on their combined wage income, deductions, adjustments, and credits, but can divide the total number of allowances between them in any way they wish. On separate returns, the allowances must be figured separately.

If you work for only one employer and are unmarried, you may claim an additional withholding allowance. If you are married, you may claim the additional allowance if you work for only one employer and your spouse does not work, or your wages from a second job or your spouse’s wages are $1,500 or less. This special allowance is only for withholding purposes. You may not claim it on your tax return.

If you work for two or more employers at the same time, you figure your withholding allowances based on the total income, and then split the allowances between the two jobs in any way you wish. Do not claim the same allowances with more than one employer at the same time.

File a new Form W-4 each year for withholding allowances based on your anticipated deductions and credits. Furthermore, you may have to file a new form to increase your withholding if withholding allowances you had been claiming are no longer allowed (26.5).

IRS review of Form W-4.

Employers are not required to submit Forms W-4 to the IRS for review unless the IRS sends written notice directing the employer to provide the W-4 forms of specified employees. The IRS uses the information on Form W-2 wage statements to spot employees who are not withholding enough federal income tax from their income. If the IRS determines that too many withholding allowances are being claimed, the IRS can issue a “lock-in letter” requiring your employer to limit the number of allowances to a specified maximum. You will receive a copy of the “lock-in letter” and be given an opportunity to dispute the IRS determination before your employer adjusts your withholding.

The IRS may impose a $500 civil penalty if you did not have a reasonable basis for claiming allowances that reduced your withholding on Form W-4. There is also a criminal penalty of up to $1,000 plus a jail sentence upon conviction for willfully supplying false information.

When to file a new Form W-4.

You should file a new Form W-4 any time the number of your exemptions or withholding allowances increases or decreases, such as when a child is born or adopted, you marry, you get a divorce, or your deductible expenses change.

Your employer may make the new Form W-4 effective with the next payment of wages. However, an employer may postpone the new withholding rate until the start of the first payroll period ending on or after the 30th day from the day you submit the revised form.