The Form W-4 worksheet is designed to calculate withholding on wages. In reality, taxpayers may have other sources of income not subject to withholding. If you only rely on the W-4 worksheets for withholding, it may result in an unexpected tax bill. For example, you work part-time for $20,000 in wages, while your spouse earns $500,000. Your total taxable income for your household could fall into the 39.6 percent tax bracket. Even if you complete your W-4 as single with zero exemptions — the combination that results in the most withholding — you may still be under-withholding because your filing status and exemptions do not account for other sources of income. You may not be withholding enough if you have significant nonwage income, such as interest, dividends, alimony, unemployment compensation or self-employment income. The only way to increase your withholding is to specify an additional amount to be withheld from each paycheck on line 6 of Form W-4. This may also be an easy option if you know you may owe more as a result of other taxes, such as, self-employment tax or household employment tax.
One way to quickly estimate if you are withholding enough is to divide your withholding on your paycheck by your taxable income. If the percentage is less than your effective tax rate, you may not be withholding enough. Generally, you can change your W-4 as many times throughout the year as you find necessary.
While your withholding may be sufficient when you estimate your taxes early in the year, various events can cause you to owe additional taxes. For example, you may sell a piece of property or marketable securities for a gain, or may have an unexpected change in your filing status. If any of these scenarios occur, you should determine the additional taxes you owe. You can either increase your withholding for the remainder of the year or make a tax estimated tax payment. If you have the ability to increase withholding in lieu of making tax estimates, this might be a better and safer way to pay your tax liability, as withholding is viewed as being paid evenly throughout the year — even if it is all withheld from the very last paycheck of the year.
There are two safe harbors to avoid being assessed penalties for underpayment. You must withhold 90 percent of your expected tax for 2014 or meet 100 percent of your prior year total tax, whichever is less. If your adjusted gross income is more than $150,000 married filing jointly, you must meet 110 percent of your prior year tax liability. It is important to have your tax consultant review your tax situation quarterly, or at the very least, midyear to see if you are on the right track to avoid penalties.
William G. Lako, Jr., CFP®, is an Executive in Residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial. Mr. Lako is a Certified Financial Planner™ professional.