The word taxes bring shudders to many people. However, taxes aren't necessarily a bad thing. On some level, your taxes fund services that benefit the public such as Social Security and Medicare. Paying too much, however, amounts to an interest-free loan over and above your fair share and may leave you with a higher burden than what the government assessed you. In this article, we highlight some reasons that can lead to an overpayment in taxes and how best to avoid them.
Key Takeaways
- Withholding taxes are deducted from your paycheck by your employer and include federal, state, local, and FICA taxes.
- Your withholding is excessive if you receive a large tax refund, which means you're paying too much in taxes with each paycheck.
- You may want to consider adjusting the withholding amount with your employer.
- Common reasons your withholdings might change include marriage, additions to the family, or job loss/gain.
- The ideal tax refund is exactly zero, which means you didn't "loan" any money to the IRS on an interest-free basis.
What Is Withholding Tax?
The withholding tax is the amount of money your employer deducts from your paycheck every time you pay. The amount of money that you pay in withholding (as it's often simply called) relies on two factors:
- Your income
- Form W-4, which tells your employer how much to deduct from your earnings based on your marital status, dependents, and allowances
Withholding covers a few different types of taxes, including federal, state, and local taxes. Your employer also withholds Federal Insurance Contributions Act (FICA) taxes, which are used to fund Social Security and Medicare.
A Clear Sign You're Overpaying
The most obvious sign that you are paying too much tax is the size of your refund. The average refunds early in the filing season tend to be just over $3,000 as the people who expect to get money back from the Internal Revenue Service (IRS) tend to file their returns early.
Filing early (and getting a return) can be a boon, especially when there are other life events that can take priority. For instance, you may be expecting a new addition to the family, there may be a job loss in the family, or you may have a dependent move into your home. Any one of these situations can occur well before you have the time to adjust the withholding taxes with your employer.
If you get several thousand back from the IRS every year, then you are definitely paying too much in taxes with every paycheck.
Reasons to Adjust Your Withholding Tax
The most common life events that can influence the amounts you should be withholding off your checks include:
- Marriage: Your spouse's income can impact your tax bill as a household. If your spouse is a dependent, then your withholding amounts should be adjusted downward. Divorce obviously has an effect as well and requires an update, particularly when dependent children are involved.
- Addition to the Family: The birth or adoption of a child reduces the amount you should be withholding because you are adding a dependent to your household.
- Changes in Income: If you aren't accounting for non-wage or income from a second job, you usually end up owing the government more. If you adjust your withholding up to reflect other income and these sources dry up, those extra withholding amounts need to be removed. For instance, you may want to consider doing this if you had a bad year in a side business.
Some company payroll departments will prompt you to update the W-4 if they are aware of these life changes. For most people, however, it falls on you to get the updated paperwork to them.
Use the IRS Tax Withholding Estimator to determine how much tax should be withheld from your paycheck. You'll need your paystubs, information from any other income you receive, and your most recent tax return to use the tool.
When Should You Adjust Your Withholding?
It always makes sense to adjust your withholding well before you expect your tax return. Do it sooner rather than later any time you expect a large tax credit or deduction. That's because there is a growing opportunity cost the longer you wait for the money.
In addition to the three examples above, there are education credits, dependent care credits, charitable giving deductions, and other things that can be converted to withholding reductions using worksheets from the IRS.
In fact, instead of waiting for the return and adjusting your W-4 for the year ahead, you can work through the IRS's own withholding calculator and even run some scenarios.
Reasons to Intentionally Overwithhold
There are certain situations where people might opt to withhold more money from their paychecks intentionally. One common reason is to ensure a larger tax refund at the end of the year. Some people prefer this approach to force them to save money. If that money isn't in their bank account, it is more difficult to spend (though this can be a limitation discussed in the next section).
For individuals with variable income or multiple income streams, overwithholding can act as a safeguard against an unexpected tax bill. It can be challenging to accurately predict annual earnings in these situations, and having more taxes withheld can act somewhat as an insurance policy to make sure there's nothing unexpected (at least unexpected in the negative sense) that happens come tax time.
Some people may also choose to overwithhold from certain roles because other positions do not withhold tax. For example, consider someone who receives a W-2 from their full-time job and a 1099 as a part-time contractor. No taxes are withheld for their 1099 job. Therefore, people may intentionally tell their W-2 employer to withhold "too much" to compensate for where they can't withhold.
People may also overwithhold if they've been burned with a penalty for underpayment on estimated taxes in the past. In most cases, taxpayers who owe less than $1,000 or have paid at least 90% of their taxes leading up to their return will not be assessed a penalty. However, the IRS may impose a penalty (which can be waived) should you fall below certain thresholds.
Last, people may withhold too much for taxes if they expect certain things to happen in the year. For example, that person may plan on giving a large gift that exceeds the IRS gift tax exemption. In 2023, if a taxpayer awards gifts greater than $17,000, they may tax on the transaction. In 2024, this increases to $18,000. The taxpayer may choose to withhold more than need to in advance of actually needing it.
There is a list of penalties you may incur as part of your tax return. Take note that the IRS does charge interest on penalties.
Disadvantages of Withholding Too Much Tax
Overpaying taxes and having too much tax withheld has several disadvantages. First, it essentially means you're giving the government an interest-free loan. Your overpayment sits with the government until you request it as part of your refund.
Overpaying taxes can expose you to the impact of inflation over time. The value of money tends to decrease, and by delaying access to your funds, you may experience a reduction in purchasing power. The $1,000 refund you receive in the future is not worth the same today in inflationary times. Another way to consider this is to consider how you could have invested these funds and grown the $1,000 over time.
Last, there is a psychological barrier to getting a refund. Relying on a large tax refund as a financial strategy may not be the most efficient way to manage your money. If, for whatever reason, that windfall isn't there one year, you may be left wondering how you can come up with a large sum of money like you'd come to expect come the spring.
Why Should I Adjust my Withholding Tax?
You should adjust your withholding tax every time you have an important life event. You may want to make changes for the following reasons: your marital status changes, you have a child or another dependent, your spouse loses their job or finds a new one after being unemployed. Adjusting your withholding tax allows you to increase or decrease the amount of money your employer deducts from your paycheck. If you pay more money, your take-home pay is reduced and you may end up with a tax refund. Doing so effectively gives the IRS a tax-free loan for a full year. If you pay less through your withholding taxes, you may owe money when you file your return.
Who Is Exempt From Withholding?
If you work, you will have to pay taxes on any income that you earn. But you may qualify for an exemption from withholding as long as you "have had no tax liability for the previous year and must expect to have no tax liability for the current year." This means that the total tax calculated on Form 1040 is less than the total amount of refundable credits you claim.
You must inform your employer not to deduct withholding taxes using Form W-4. A new form must be completed each year. Keep in mind that your employer will still withhold FICA taxes, which are used to fund Social Security and Medicare.
How Will Any 401(k) Contributions I Make Impact My Withholding Tax?
Consider making contributions to a 401(k) if your employer offers one. Not only does this give you a nest egg for your retirement in the future, but you'll also lower your taxable income. This effectively lowers the amount of tax withheld from your paycheck.
The Bottom Line
No one likes to pay taxes so it may seem like a big win when you see a big tax refund. In reality, you're paying too much in taxes every time your employer deducts them from your paycheck. When this happens, it means you're giving the IRS an interest-free loan for an entire year.
There are ways to avoid doing this and keep more money in your pocket—especially when there's a life-changing event like a change in marital status, a new dependent, or a job loss/gain. Consider dropping the amount that's deducted by your employer by updating your W-4. Last, be mindful that there may be situations where it actually does make sense to withhold more in taxes.
