Updated by: Business First Family September 28, 2018 in Finance
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Did you know that your charitable donations could be tax deductible? You can get a tax break while helping other people, an ideal situation for most business owners. Your business can easily make tax deductible donations, but there is a specific process you need to follow to take advantage of this. Here’s how to make tax deductible donations for your company.
Pick A Place
The first step in making a charitable donation is picking a place. It’s important to pick a charity that you feel comfortable supporting, so take your time deciding. Look into the practices of the organization before donating and consider doing a ratio analysis to identify the best options. The place you donate must also have the proper certification for the money to be tax-deductible. A qualified organization will most likely tell you they are tax-exempt. Donations to religious organizations or non-profit firehouses are often tax-exempt even if they don’t state it. Regardless, it’s important to ask questions and do your research to conform the organization’s status.
Consider What To Donate
The most common type of donation is cash, but there are other ways to make a tax-deductible contribution. Think about what you can afford to give. Furniture, textiles, stock and property could all be eligible for a tax-deductible donation. Volunteering expenses may even be allowed, depending on the specific situation. Moreover, you should consider anything you will receive in return for your donation. You must subtract the value of those items from your contribution. You have many options when thinking about what to donate, so explore all possibilities before committing.
Receive A Record
For the tax-deductible donation to be “real”, you need proper documentation. Ask for a record of every transaction and review it. The record should be clear and properly dated, outlining who is giving and receiving the money. Examples include receipts and bank statements. You should also get a receipt for non-monetary donations. For example, if you donate furniture, Habitat for Humanity can give you a record for your donations. In many cases, a tax-deductible donation will not be acknowledged if there isn’t proof. Organizations are typically willing to work with you in this way, but you need to know to ask for transaction records. It’s up to you to stay on top of record keeping throughout the year.
Know Your Limit
The contribution you make to a charity or organization is only deductible for that year. There are specific rules for things like Goodwill clothing donations. As stated earlier, make sure to always get a receipt, or your options for a tax break might be limited. Additionally, the IRS limits the amount of tax-deductible donations you can make, which you would not know unless you attended any online accounting courses. Typically, the IRA says the donations will be deductible for up to 50% of your organization’s adjusted gross income annually. Most donators don’t come close to this limit, but it’s good to keep in mind. Know your donation limits to maximize your contribution to a company.
Take The Deduction
Depending on your type of business, you will file taxes differently. Some businesses file on an individual tax return. A corporation files through its business. No matter how you file, remember to own your donation when filing out the paperwork. There is a section “Gifts to Charity” that requires you to itemize your contribution. You will have to report whether you paid by cash, check or another method. The form has further instructions for gifts over $250. If you don’t report the charitable donation properly, you can’t claim a tax deduction on it. Make sure you have all the correct documents to take the deduction.
When thinking about tax-deductible donations, it’s important to have a process. You must first find a place that allows your contribution to be tax-deductible. Then, think about whether or not you want to donate money or goods. Keep a receipt or record of every transaction, and know the restrictions surrounding your contribution. Finally, be sure to itemize your deduction on your taxes. Following this guide can help you determine how to make tax deductible donations for your business, which will leave you more money for other crucial business expenses, like your independent contractor insurance.
Mark Cussen, CMFC, has 13+ years of experience as a writer and provides financial education to military service members and the public. Mark is an expert in investing, economics, and market news.
Each year, many Americans fastidiously record their charitable contributions, mortgage interest, property taxes, and various other expenses in hopes of clearing the dollar threshold that will enable them to claim itemized deductions that are greater than the standard deductions. But beyond those itemized deductions, certain other deductions can be declared, even if the taxpayer is unable to itemize them. Such expenses are known as above-the-line deductions.
What Are Above-the-Line Deductions?
Above-the-line deductions are expenses that are deducted to calculate an individual’s adjusted gross income (AGI). These differ from itemized deductions, which are the dollar amounts deducted from the determined AGI. The following examples represent above-the-line expenses:
- Domestic Production Activities: Up to 9% of activities related to the domestic production of certain goods or services, such as engineering or architectural concerns, may be deducted under certain conditions.
- Retirement Plan Contributions: All contributions made to traditional IRAs and qualified plans such as 401(k), 403(b), and 457 plans are deductible. Taxpayers with incomes above a certain level who contribute to both a traditional IRA and a qualified plan are subject to a graduated phaseout reduction on the deductibility of their IRA contributions.
- HSA, MSA Contributions: All contributions to Health Savings Accounts and Archer Medical Savings Accounts are fully deductible, as long as taxpayers do not have access to any kind of group policy coverage, including that offered by fraternal or professional organizations. The purchase of a qualified high-deductible health insurance policy is also required.
- Health Insurance premiums: The cost of premiums paid for individual health insurance policies, including high-deductible policies, are fully deductible for self-employed taxpayers. As with HSAs and MSAs, the taxpayer cannot have access to group health coverage.
- Self-Employed Business Expenses, SE Tax: Virtually any expense related to the operation of a sole proprietorship is deductible on Schedule C. This includes rent, utilities, the cost of equipment and supplies, insurance, legal fees, employee salaries, and contract labor. This also includes one-half of the self-employment tax that must be paid on this income.
- Alimony: Payments made to a spouse pursuant to a divorce decree that are not classified as child support usually count as alimony. Payments of this type are deductible from gross income unless they are “made under a divorce or separation agreement executed after Dec. 31, 2018” or were modified in certain ways after that date. If your divorce agreement predates that date, check with your accountant to confirm that alimony payments are still deductible. This change came as part of the Tax Cuts and Jobs Act of 2017.
- Educator Expenses: These include unreimbursed qualified expenses of up to $250 ($500 for joint filers if both fall under this category). Qualified expenses include teaching supplies, books, and other ordinary expenses commonly associated with education. This deduction is available to educators who teach grades K-12 who work at least 900 hours during the year.
Note to Teachers
When filing their 2020 taxes, educators may deduct unreimbursed expenses for COVID-19 protective items incurred since March 12, 2020, according to new IRS guidance. These costs can be included in their $250 maximum educator expense deduction
- Early Withdrawal Penalties: Any penalties paid for the early withdrawal of money from a CD or savings bond that is reported on Form 1099-INT or 1099-DIV can be deducted.
- Student Loan Interest: All interest paid on federally-subsidized student loans up to a certain amount is deductible, provided the taxpayer’s income does not exceed the annual limits. For 2019, those limits are $85,000 for single, head-of-household, or qualifying widower filers and $170,000 for joint filers.
- Tuition and Fees: In some cases, it is more advantageous for taxpayers to deduct the costs of tuition and other educational expenses paid to qualified educational institutions than to claim an educational tax credit.
The Bottom Line
Any or all of these deductions can be taken in addition to the itemized deductions for eligible taxpayers. Of course, there are rules and limitations that must be observed. For more information on above-the-line deductions, read the instructions for Form 1040 on the IRS website or consult your tax advisor.
With April 15 the tax deadline, the clock is ticking on ways Americans can keep more of their hard-earned money in their pockets — and less of it in Uncle Sam’s.
The problem is, U.S. taxpayers have historically left too much tax return money on the table — mostly because they haven’t taken or known about all the breaks and deductions that were allowable.
That’s a big problem. A University of California research paper notes that Americans pay about $1.5 trillion income taxes every year, and that’s a big number — approximately 8.3% of U.S. gross domestic product heads straight from taxpayer bank accounts into the U.S. Treasury.
Furthermore, the report states that American taxpayers routinely sell themselves short on their tax returns, walking away from money they could have saved, especially in key areas like retirement savings and claiming U.S. government tax deductions and benefits.
It all comes down to the tax breaks, in the form of tax deductions and tax credits, you can take full advantage of — all allowable under U.S. law.
Tax Deductions vs. Tax Credits
In your preparation to save money on your taxes this year, it’s helpful to understand the difference between two key tax breaks — deductions and credits.
- A tax deduction lowers the amount of income the IRS can tax — the standard deduction is a good example of a common tax deduction available to U.S. taxpayers.
- A tax credit directly slashes your tax bill to Uncle Sam — it’s a dollar-for-dollar cut on your tax bill.
Basically, tax deductions are subtracted off the amount of taxable income you earn. If you stack up enough tax deductions, it’s possible to overpay the IRS, in which case you get a refund.
Tax Deductions Going Away in the 2019 Tax Year
It’s helpful to know which tax deductions and tax credits will disappear in 2019. You could have more opportunities to save than you realize, depending on your tax status among other things.
But if you’re going to take an inventory of potential tax breaks going forward, it’s helpful to know what breaks won’t be there for the 2019 tax year, and should be factored into your tax return planning before April 15.
These are the tax deductions going away until at least 2025, when they could return depending on the political winds blowing in Washington, D.C.
- The standard $6,350 deduction. (It’s increased to $12,200)
- Personal exemptions.
- Unlimited state and local tax deductions.
- A $1 million mortgage interest deduction. For purchases after Dec. 15, 2017, the deduction is limited to $750,000.
- An unrestricted deduction for home equity loan interest.
- Deductions for unreimbursed employee expenses.
- Miscellaneous itemized deductions.
- A deduction for moving expenses.
- Unrestricted casualty loss deduction.
- Alimony deduction for divorce agreements made after 2018.
- Deductions for certain school donations.
- Deductions from tax extenders.
Getting Your Fair Share With These 10 Tax Breaks
The good news is that there are new tax breaks that should — or could — incentivize Americans to save more money on their tax returns.
So, why leave money on the table that the IRS can shovel into its pockets?
Don’t do it – use these money saving tips to financially maximize your 2019 tax return experience that’s due in 2020, and don’t be the taxpayer who overpays the federal government every April when they didn’t have to.
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Note: August 2019 – this Fact Sheet has been updated to reflect changes to the Withholding Tool.
FS-2019-4, March 2019
The federal income tax is a pay-as-you-go tax. Taxpayers pay the tax as they earn or receive income during the year. Taxpayers can avoid a surprise at tax time by checking their withholding amount. The IRS urges everyone to do a Paycheck Checkup in 2019, even if they did one in 2018. This includes anyone who receives a pension or annuity. Here’s what to know about withholding and why checking it is important.
Understand tax withholding
An employer generally withholds income tax from their employee’s paycheck and pays it to the IRS on their behalf. Wages paid, along with any amounts withheld, are reflected on the Form W-2, Wage and Tax Statement, the employee receives at the end of the year.
How withholding is determined
The amount withheld depends on:
- The amount of income earned and
- Three types of information an employee gives to their employer on Form W–4, Employee’s Withholding Allowance Certificate:
- Filing status: Either the single rate or the lower married rate.
- Number of withholding allowances claimed: Each allowance claimed reduces the amount withheld.
- Additional withholding: An employee can request an additional amount to be withheld from each paycheck.
Note: Employees must specify a filing status and their number of withholding allowances on Form W–4. They cannot specify only a dollar amount of withholding.
Everyone should check withholding
The IRS recommends that everyone do a Paycheck Checkup in 2019. Though especially important for anyone with a 2018 tax bill, it’s also important for anyone whose refund is larger or smaller than expected. By changing withholding now, taxpayers can get the refund they want next year. For those who owe, boosting tax withholding in 2019 is the best way to head off a tax bill next year. In addition, taxpayers should always check their withholding when a major life event occurs or when their income changes.
When to check withholding:
- Early in the year
- If the tax law changes
- When life changes occur:
- Lifestyle – Marriage, divorce, birth or adoption of a child, home purchase, retirement, filing chapter 11 bankruptcy
- Wage income – The taxpayer or their spouse starts or stops working or starts or stops a second job
- Taxable income not subject to withholding – Interest, dividends, capital gains, self-employment and gig economy income and IRA (including certain Roth IRA) distributions
- Itemized deductions or tax credits – Medical expenses, taxes, interest expense, gifts to charity, dependent care expenses, education credit, Child Tax Credit, Earned Income Tax Credit
How to check withholding
- Use the Tax Withholding Estimator on IRS.gov.
The Tax Withholding Estimator works for most employees by helping them determine whether they need to give their employer a new Form W-4. They can use their results from the estimator to help fill out the form and adjust their income tax withholding. If they receive pension income, they can use the results from the estimator to complete a Form W-4P, Withholding Certificate for Pension and Annuity Payments PDF , and give it to their payer.
- Use the instructions in Publication 505, Tax Withholding and Estimated Tax.
Taxpayers with more complex situations may need to use Publication 505 instead of the Tax Withholding Estimator. This includes employees who owe, the alternative minimum tax or tax on unearned income from dependents. It can also help those who receive non-wage income such as dividends, capital gains, rents and royalties. The publication includes worksheets and examples to guide taxpayers through these special situations.
To change their tax withholding, employees can use the results from the Tax Withholding Estimator to determine if they should complete a new Form W-4 and submit to their employer. Don’t file with the IRS.
Those who don’t pay taxes through withholding, or don’t pay enough tax that way, may still use the Tax Withholding Estimator to determine if they have to pay estimated tax quarterly during the year to the IRS. Those who are self-employed generally pay tax this way. See Form 1040-ES, Estimated Taxes for Individuals, for details.
- How to Change Mortgage Amortization
- Advantages & Disadvantages of Second Trust Mortgages
- How to Fix Home Loan Rates
- How to Merge a Mortgage
- How to Increase a Mortgage to Fix Up a House
You should keep a few rules in mind when you are taking out a mortgage and looking to maximize the value of the mortgage interest tax deduction. The first is to keep your debt under the IRS’s maximum deduction threshold of $1 million for purchase debt and $100,000 for equity debt. The second is to remember that while interest is almost always fully tax-deductible, you cannot count on anything else. As such, paying a little bit more interest can actually be a good thing.
Total up all of your non-mortgage debts. If they add up to $100,000 or less, consider including them in your mortgage if you can take cash out above the amount of your existing balance.
Determine if you need money to improve or repair your house. If so ,you can combine this with what you spend to buy your house to use as much as possible of the IRS’s limit of $1 million of home purchase debt.
Identify a mortgage lender and contact it for rates.
Work with your desired lender to identify a mortgage that gives you a suitable rate and terms. Seriously consider a 30-year mortgage since it will not only give you the lowest payment but will also lead to you paying more interest, maximizing your tax deduction.
Close your mortgage without paying discount points. Discount points lower your interest rate and reduce your tax deduction. If possible, close your mortgage without paying closing costs, trading a slightly higher rate for having your lender absorb these expenses. This will also increase your tax-deductible interest.
- IRS.gov: Publication 936 – Main Content
- Kiplinger: Tax Breaks for Refinancing
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the “Minnesota Real Estate Journal” and “Minnesota Multi-Housing Association Advocate.” Lander holds a Bachelor of Arts in political science from Columbia University.
With these seven tips, anyone can learn how to effectively reduce their tax liability and maximize their deductions. But it is important to remember that you can’t have good tax planning without the planning. Once you become familiar with the basics and how to spot opportunities, the process will seem simpler and routine.
Effective tax planning is a continuous activity.
In order to minimize your tax payments and make the most of your income, you’ll need to take advantage of the opportunities that avail themselves all year round. You’ll want to keep track of the items that are discussed below and calculate your estimated tax periodically during the year. Doing so will help you can make timely decisions that can effectively reduce the taxes that you owe. This could include selling poorly performing stock resulting in a loss, waiting to sell your home, deferring a bonus, adding to a retirement plan or contributing to flex spending for medical needs. The timing of your taxable events may determine not only how much tax you owe this year but also in future years. You want to have plenty of deductions to take in years when your income is highest and not lose tax benefits that can be deferred during years of lower income. In order to make this happen effectively, you will need to conduct periodic tax planning all year round.
Keep accurate, organized records.
You can gather all your receipts and the notes that you wrote on dinner napkins from the shoe box and try to reconstruct your taxable events. But this doesn’t usually bode well in practice. It’s more likely that you’ll end up counting too few deductions and paying too much income taxes. If you’re not naturally organized, do your best to make timely entries concerning your transactions in a notebook or a spreadsheet. Set aside time just one evening every month to be responsible! File your receipts and statements from banks and stock brokers conveniently. And remember to keep your records safe for up to six years after the date the tax return is filed in the event you need to deal with an audit.
Use available itemized deductions, business expenses and tax credits.
Itemized deductions and business expenses on your tax return act to reduce your adjusted gross income. Schedule A of your IRS Form 1040 includes personal, itemized deductions for health care expenses, charitable donations, mortgage interest, taxes (property, state and local), home office costs, employment seeking expenses and some others. While you may be better off with a standard deduction, you should always review the complete list of itemized deductions early in the tax year to determine whether it makes sense to take advantage of some of these benefits. The same approach should be taken in determining deductions for business expenses, which is listed in Schedule C of Form 1040. Business deductions include expenses incurred for advertising, use of an automobile, commissions and fees, depreciation, the cost of resold products, labor costs, rent and utilities, most insurance as well as business equipment (such as a phone, computer, peripherals and office furniture.)
Tax credits are even more powerful than deductions in decreasing your tax liability. The credits taken directly against the amount of tax that you owe, dollar for dollar. Available credits include those for child and dependent care, college funds and other incentive based initiatives. Other tax credits are available for certain business activities and many for low income persons such as the EITC (Earned Income Tax Credit).
Move income to non-taxable accounts and programs.
Pursuant to Section 125 of the Internal Revenue Code (IRC), you can transfer income into a tax-free employee benefit plan known as a “cafeteria plan.” Contributions made typically result in pre-tax benefits. A flexible spending account (FSA) is commonly used for medical and health care, child care and other expenses such as transportation and parking. A health savings account (HSA) is also tax-free but limited to qualified medical and healthcare expenses. An HSA may be used to pay the deductible portion of healthcare services (doctor visits, lab tests and hospital visits.) A qualified education assistance program may also be available from your employer as another example of a non-taxable benefit. Also related are Education Savings Accounts (ESA) which help parents and students save and contribute money, tax-free, to provide for continued education such as a college plan.
Make income contributions to retirement accounts.
If you’re in a company that provides a 401k plan, you should consider making contributions. You can also sign up for an IRA (Individual Retirement Account) on your own. In both instances, the contributions made to your nest egg are tax free. Roth accounts work the other way around – contributions made are not given any special treatment. But withdrawals of those amounts and any investment earnings at retirement are not subject to federal and state income taxes.
Report your income accurately and honestly.
Make sure that your tax forms are filled out honestly and that they take a position that can be justified. The IRS recognizes that sometimes there are tax reporting errors made in good faith or that may have been inadvertently overlooked. If you owe additional taxes, you may be required to pay a small penalty. But if the IRS believes that you made efforts to willfully evade paying taxes such as failing to report income or to provide information, you could be subject to criminal charges. If you realize that you’ve made a material mistake later, you can file an amended return (Form 1040-X).
File a tax return even if you don’t owe any income tax.
If you don’t believe that you owe any income tax, it’s understandable to feel that you shouldn’t need to file a tax return. But there is a difference between filing a return and paying taxes. The IRS has guidelines with regard to who must file a return. Even if you don’t owe any income tax, you still may be required to file a return. The term “voluntary” that many cite comes from the notion that if you owe tax, you must “volunteer” a return – not that reporting or paying taxes are voluntary in nature. The failure to comply with rules for filing and paying income taxes can result in civil and criminal penalties. Even if you can’t afford to pay the amount owed when due, it is best to file and try to make arrangements with the IRS to deal with your hardship.
Using software and professional help to minimize your tax liability.
If you intend to use software to help with the preparation of your tax returns, make sure that it is produced by a reliable company. Perform research prior to any purchase. Using professional services such as an experienced, certified accountant will frequently provide excellent results. When an estate is involved, the use of a tax or estate planning attorney is highly recommended as mistakes can result in significant and unnecessary tax liability.
The qualified business income (QBI) deduction is the centerpiece provision of the Tax Cuts and Jobs Act and applies from 2018 through 2025. Qualified business income is aggregated from a partnership, S corporation, limited liability company and sole .
20% QBI Deduction for Pass-Through Income
The qualified business income (QBI) deduction is the centerpiece provision of the Tax Cuts and Jobs Act and applies from 2018 through 2025. Qualified business income is aggregated from a partnership, S corporation, limited liability company and sole proprietorship, and it is claimed on the individual tax return. Overall, you take 20% of QBI from a trade or business plus 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income. There are three limitations associated with the deduction.
- Specified Service Trades or Businesses
The first limitation is designed to deter high-income taxpayers from trying to convert wages or other compensation for personal services into income that qualifies for the deduction. Trades or businesses with the performance of services in the following fields are subject to the limitation: health, law, consulting, athletics, financial or brokerage services or where the principal asset is the reputation of the employee or owner.
The QBI or Section 199A deduction doesn’t apply to specified service trades or businesses (SSTB) when taxable income is above $426,600 for joint filers and $213,300 for other filers and is partially allowed when taxable income is between $326,600-426,600 for joint filers and between $163,300-213,300 for other filers (Tax Year 2020 levels).
- Wages / Unadjusted Basis Immediately After Acquisition (UBIA)
The QBI deduction cannot exceed the greater of:
a) 50% of taxpayer’s allocable share of W-2 wages, OR
b) 25% of wages plus 2.5% of unadjusted basis (in depreciable property) immediately after acquisition
This limitation applies to all businesses when taxable income is above $426,600 for joint filers and $213,300 for other filers and is partially applied when taxable income is between $326,600-426,600 for joint filers and between $163,300-213,300 for other filers (Tax Year 2020 levels).
It’s important to note that S corporations pay their owners W-2 wages, but sole proprietorships and partnerships do not. This can have an impact on how this QBI limitation is calculated.
- Taxable Income Limitation
The 20% QBI deduction is limited to 20% of taxable income without regard to net capital gain income. The 20% taxable income limit applies to the taxpayer’s combined qualified business income from all businesses, whereas the prior two limits are applied at the activity or trade or business level.
Checklist to Maximize the QBI Deduction
Here are some planning tactics around the various limitations that may help you optimize your QBI deduction. This checklist is not exhaustive and there is some overlap between categories.
- If you have no or low qualified business income, see if there are opportunities to become a business owner, such as an employee becoming a consultant. Remember to take into account all considerations, such as a benefits package.
- If you’re a specified service trade or business and subject to the phase-out, think about filing separately instead of jointly; or establishing a separate business, a separate entity or becoming a C corporation. Be careful though because there are some rules constraining these tactics.
- If you’re subject to the wage / UBIA limits, think about hiring employees instead of contractors; increasing wages; purchasing assets; becoming an S corporation instead of a partnership or sole proprietorship. Remember to take into account all factors, such as any increased payroll tax and a benefits package provided to employees.
- If you’re over the taxable Income threshold, think about deferring income and accelerating expenses, or making a retirement plan contribution to bring down taxable income in the current year.
- If you’re subject to the 20% taxable income limit, think about trying to increase taxable income, such as taking on a second job.
- There are other planning strategies too, such as aggregating multiple business units to optimize the three components and limitations (QBI, Wages, UBIA).
Example – Reducing Taxable Income to Avoid Phase-out
- Married filing joint return
- Taxpayer has a job earning $250,000
- Spouse owns a business with $150,000 in income (a specified service trade or business)
- Other income of $60,000
- Taxable income above $421,400 threshold (TY19 threshold)
- Column 1: No QBI deduction because taxpayer is above the threshold.
- Column 2: The spouse makes a maximum contribution to a SEP plan of $27,950. This reduces taxable income below the threshold and results in a QBI deduction of $5,366.
- Column 3: The combination of the SEP deduction and QBI deduction results in a total tax savings of over $11,000.
Advisory Services – Show Clients the Return on Investment
As tax professionals perform advisory services and provide their clients with tax planning strategies, it’s important to point out the return on investment, so clients can see the value of the services. i.e. How much they’re saving versus how much it costs them to do the extra work. Point out the fact that you’re allowed to reduce their tax bill as long as you follow the law. The value of a good tax professional is to look for tax savings opportunities for their clients and QBI is a nice place to start!
Mike D’Avolio, CPA, is a senior tax analyst with Intuit ProConnect Group . D’Avolio has been a small-business tax expert for more than 20 years and serves as the primary liaison with the Internal Revenue Service for tax law interpretation matters. He manages all technical tax information, and supports tax development and other groups by providing them with current tax law developments, analysis of tax legislation and in-depth product testing of Intuit’s professional tax software products including Lacerte , ProSeries and ProConnect Tax Online .
Accurately calculate your withholding for federal income taxes
Dealing with your taxes is as much a matter of planning for next year as it is finishing and filing your tax return this year. Life isn’t stagnant, and your income or deductions can change, but you can always adjust your withholding to avoid receiving too large of a refund or, even worse, owing a significant balance to the Internal Revenue Service (IRS) come tax time.
Finding just the right level of withholding can be a balancing act—particularly if you anticipate big changes in the coming year—or personal events with tax implications, like getting married or divorced, or having a child. Some general rules of thumb and an understanding of the process can help. The IRS provides some interactive tools to help you along.
Why Would a Refund Be a Bad Thing?
Receiving a tax refund actually means you gave the IRS more from your paycheck than you had to—money that you could otherwise have spent on bills, pleasure, retirement savings, or investments. The IRS held onto that extra money for you all year and is now returning it to you when you get a tax refund—without interest. It would have served you better in a simple savings account.
New Withholding Form
Calculating a level of withholding that’s just right can sometimes take as much time as preparing your tax return. The IRS introduced a new Form W-4 that covers tax year 2020 moving forward. It aligns with changes made by the 2017 Tax Cuts and Jobs Act that eliminated the personal exemption, which tied into allowances. The new form aims to simplify the process and uses a question-and-answer format. It allows you to adjust withholdings upward or downward.
If you expect significant investment income or have other outside income not subject to withholding, you can have more withheld from your paycheck to cover it at tax time. If you overwithhold, you’ll get a refund. Alternatively, if you adjust your withholding amount too far downward, you will owe the IRS at tax time and could also incur a penalty.
Paying at least 90% of your tax owed is usually enough to escape the estimated tax penalty.
Calculating Withholding More Accurately
One way to adjust your withholding is to prepare a projected tax return for the year. Use the same tax forms you used the previous year, but substitute the current tax rates and income brackets. Calculate your income and deductions based on what you expect for this year, and use the current tax rates to determine your projected tax.
Then, use the withholding calculator on the IRS website to see the suggested withholding for your personal situation. The number of dependents you support is an important component of your analysis, as is the number of streams of income.
Calculating the Effect on Your Paychecks
Once you’ve figured out your withholding, you can use this number to see what the tax impact will be on your next paycheck. Plug your newly calculated withholding information into a payroll calculator. Make sure you have a recent pay stub handy so that you can use your actual income amounts.
Calculating Your Total Withholding for the Year
Take your new withholding amount per pay period, and multiply it by the number of pay periods remaining in the year. Next, add in how much federal income tax has already been withheld year-to-date. This total represents approximately how much total federal tax will be withheld from your paycheck for the year.
Ask yourself whether you can easily write a check to the government plus a little interest if your calculations show that you’re going to owe the IRS $500 in April. Now is the time to adjust if you can’t.
You can now compare your total withholding to your tax liability projection. If your withholding amount is larger than your tax liability, that’s how much of a federal tax refund you can expect to receive. If your withholding is less than your tax liability, that’s how much federal tax you might have to pay when you file your tax return.
Remember, these amounts—your withholding and your tax liability—are approximate. You’re close to where you need to be if they’re not too far apart. You’re free to change your withholding at any time during the tax year if a change in your circumstances would result in a tax increase or decrease.