Here's how Reviewing Withholdings Can Reduce the Tax Burden for the Next Year

As the financial year comes to an end, it becomes important for people from all walks of life to allocate their funds for the next year and to do their taxes. The deductions from your paycheck for taxes represent an estimate, which may not accurately reflect actual tax liability. Factors such as changes in income or tax status could lead to discrepancies between the amount withheld and your eventual tax obligation. This is why reviewing taxes and conducting due diligence is crucial to ensure compliance.

Failure to get these calculations right can lead to insufficient withholding, resulting in a higher tax burden next year, due to incurring underpayment penalties. On the other hand, excessive withholding means essentially offering the government an interest-free loan, depriving yourself of funds that can be used throughout the year.

Adjustments to tax withholdings may become necessary due to various life changes, such as marriage, retirement contributions, or the addition of dependents. Such adjustments can significantly influence tax liability, emphasizing the importance of periodic evaluation.

"If your marital status has changed, your earnings have changed, or you are contributing quite differently this year to a 401(k) — perhaps to a Roth 401(k) instead of the traditional 401(k) — you need to review your tax withholding rate," says Michelle Gessner, a certified financial planner based in Houston.

Checking and modifying withholdings

To ensure your tax affairs are in order for the coming year, start by ascertaining the amount being withheld from your paychecks for federal taxes. This information is typically available on your pay stub under "federal income tax withholding" or similar headings. Alternatively, you can consult your company's human resources department for clarification.

"Tax withheld on bonuses and stock compensation is typically — though not always — withheld at a flat 22% for federal taxes. For those who are in the 22% marginal federal tax bracket, this is not a problem at all. However, those in a higher tax bracket could owe huge taxes," says Carla Adams, a certified financial planner in Michigan.

Utilizing the IRS tool

With these figures in hand, leverage the IRS tax withholding estimator tool, which provides an estimate of your tax liability for the entire year based on your current withholding. This tool advises whether adjustments are necessary to align your withholding with your anticipated tax obligation.

Upon entering your information, the tool generates an updated Form W-4, facilitating adjustments to be made by your employer.

However, it's important to note that your employer is responsible for withholding taxes only from the income they disburse, excluding earnings from freelance work or windfalls like lottery winnings. For self-employed individuals, managing taxes entails additional complexity, often requiring the use of tax software or consulting tax professionals.

Regular assessments and expert guidance

Regularly reviewing your withholding, either through the IRS tool or with assistance from a tax professional, is recommended by financial experts like Chris Mankoff. For those who are self-employed, employing tax software or seeking advice from professionals can ensure compliance with tax obligations. "A best practice is to calculate your expected tax liability throughout the year and adjust accordingly," he says.