It’s a biblical principle, “Render unto Caesar what is Caesar’s…” We are expected to pay our government any money it is owed. I don’t hear Jesus telling me to render a dime more than that, though. Yet each year I hear people say, “You won’t believe it! I got $5,000 back on my tax refund this year! Yessss!!!!!”
I’d argue that getting money back from taxes is a bad thing. You should actively be trying to avoid interest free loans to the government that you could have instead been using to destroy your debt or aggressively invest.
So, today we will talk about the new tax law, filling out your W-4 properly to take the appropriate amount of allowances, and why that is so important.
This obviously applies more broadly to the W-2 employees out there, but I’ve got info for the self-employed below, too. Stick with me.
Let’s dig in.
What’s new? And Why should we avoid the interest free loan?
Before we talk about the why, let’s talk about the what. What about the new tax law will cause your tax-situation to be better in 2018 and beyond?
Reason Number 1: The new tax brackets favor high income earners. Particularly if you have kids and get the tax-credit (AGI < $400,000 if married). The standard deductions are also nice and substantial.
Reason Number 2: The AMT is unlikely to hit you this year. Yet another reason you are likely to save money on taxes.
Why avoid the interest free loan?
Now that you understand that you are likely going to make out better under the new tax law, it begs the question of whether its a good thing or not to get money back after you do your taxes.
The simple answer is no. And here is why.
You could be using that money towards destroying debt. Assume your debt is at a 4% rate. $10,000 given to the government on loan (at 4% interest) is really costing you $10,400 to have them hold it.
If you put that $10,000 into the market instead and it earned 8% interest. You gave the government $10,800 and they gave you back only $10,000. Seems like a bad deal.
Calculating your W-4 allowances for the employed
If you want to know specifically what goes into this calculation, you can check out the W-4 worksheet (page 3) found here.
This worksheet takes into account your income, number of dependents, whether you are married, taxes, and income(s). The easier way to do it, though, is to use this calculator from the IRS.
Turbotax also has a calculator, though I found it less useful.
In order to fill out those calculators, you will need both you and your spouse’s last pay stub to see how much has been taken out. The calculator takes this into account to determine if you are on track or not.
Once the data is placed into the calculator, it will determine if you need to make any changes to your W-4 allowances.
It will then also tell you how many allowances you should adjust to so that you don’t over or under pay significantly. Remember, if you are going to miss it is better to pay the government in the end than to get a check back from an interest free loan to the government.
When I filled out my information, it told me that I needed to be taking 8 allowances and I was currently taking 4 allowances.
How much does each W-4 allowance change my pay check?
The answer? It depends.
I increased my allowances from 4 to 8 because of the above calculator. I will expect this to increase my annual takehome by $5,312 and my monthly take home pay by $443.
How do I know that?
Each allowance increases your paycheck, but it depends on your filing status and income. The following tables come from TurboTax (which took them from the official IRS publication). I thought the Turbotax tables were more reader friendly.
Table A shows you what your annual increase would be. Table B shows your the change in your monthly income with each allowance.
|Annual Income for Single Filer||Annual Income for Married Filing Jointly||Annual Value of Each Withholding Allowance*|
|Up to $13,225||Up to $30,600||$415|
|$13,226 to $42,400||$30,601 to $88,950||$498|
|$42,401 to $86,200||$88,951 to $176,550||$913|
|$86,201 to $161,200||$176,551 to $326,550||$996|
|$161,201 to $203,700||$326,551 to $411,550||$1,328|
|$203,701 to $503,700||$411,551 to $611,550||$1,452.50|
|Over $503,700||Over $611,550||$1,535.50|
*Divide your tax refund by this amount for an estimate of how many extra withholding allowances you should probably claim on your W-4 form filed with your employer.
|Annual Income for Single Filer||Annual Income for Married Filing Jointly||Monthly Value of Each Withholding Allowance**|
|Up to $13,225||Up to $30,600||$34.58|
|$13,226 to $42,400||$30,601 to $88,950||$41.50|
|$42,401 to $86,200||$88,951 to $176,550||$76.08|
|$86,201 to $161,200||$176,551 to $326,550||$83|
|$161,201 to $203,700||$326,551 to $411,550||$110.67|
|$203,701 to $503,700||$411,551 to $611,550||$121.04|
|Over $503,700||Over $611,550||$127.96|
** Multiply this amount by the number of extra allowances you will claim to see about how much your monthly take-home pay will increase.
Penalties for not paying enough
People always get antsy because they don’t want to “pay too little and get fined.” Lets talk about it.
For those wondering where the reference is coming from for this information, it is straight from the IRS (Topic Number 306).
You can avoid the fine if you do any of the following:
- Owe less than $1,000 in tax after subtracting with-holdings and refundable credits.
- If you pay withholding and estimated tax within 90% of this current year’s taxes.
- If you paid 100% of the tax you owed on last year’s tax return (actually NOT true here for high-income earners… it’s 110% if you earn more than $150,000).
How to make sure you don’t get hit with the fine
As you can see from Number 1 and Number 2, “good enough” math is the goal. You need to be within 90% of what you were supposed to owe and withhold that from your payments.
OR… you can just pay 110% of last year’s taxes. This is beneficial if you, like me, just finished training because you definitely paid less tax last year. So, just pay that amount and you won’t get hit with the fine.
If you were in full practice last year, this is a terrible method because of what was mentioned above about the new tax law. You are likely to pay a LOT less tax this year than last.
So, paying 100% of last year’s tax will just result in you giving the government an interest free loan, which is exactly what we are trying to avoid.
Check half way through the year and then again in September to make sure you are on track to be within 90% or $1,000 of this current year’s estimated taxes.
What is the fine if I make a mistake?
For 2018 you owe the taxes back + 4% interest. So, if you missed by $2,000 then you owe $80. That’s not too bad. I should mention that the fine starts earning interest from the quarter in which you should have owed the taxes.
That said, it’s not that steep of a fine unless you royally screw up and you are off by tens of thousands. Don’t do that.
What if the IRS thinks you intentionally withheld too much?
The reason you shouldn’t do that is because if the IRS determines that you intentionally falsified your W-4 allowances or quarterly payments if self-employed, the penalty can be steep (see below).
This is why I always recommend you use the IRS calculator to determine your allowances.
How steep can the penalty be? It can cost you $500 and be considered a crime.
I’ll copy this one straight from the IRS website (Pub 505):
[A tax payer] may have to pay a penalty of $500 if both of the following apply.
- You make statements or claim withholding allowances on your Form W-4 that reduce the amount of tax withheld.
- You have no reasonable basis for those statements or allowances at the time you prepare your Form W-4.
There is also a criminal penalty for willfully supplying false or fraudulent information on your Form W-4 or for willfully failing to supply information that would increase the amount withheld. The penalty upon conviction can be either a fine of up to $1,000 or imprisonment for up to 1 year, or both.
These penalties will apply if you deliberately and knowingly falsify your Form W-4 in an attempt to reduce or eliminate the proper withholding of taxes. A simple error or an honest mistake won’t result in one of these penalties. For example, a person who has tried to figure the number of withholding allowances correctly, but claims seven when the proper number is six, won’t be charged a Form W-4 penalty. However, see chapter 4 for information on the penalty for underpaying your tax.
I am self-employed, and don’t have a W-2
Should I make quarterly estimated payments?
People who should really consider making estimated quarterly payments (and are often required to by the government):
- “Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed.”
- You get paid money that does not have taxes withheld (i.e. 1099 income, large dividend income, etc) and you expect to pay more than $1000 in taxes.
If you fit into one of these groups then you should probably be making quarterly estimated tax payments. The penalties for not paying estimated payments during the year is that of a fine + interest similar to above.
Use an IRS calculator to figure it out
The simple answer is that if you earn more than $150,000 in a year, you may need to pay quarterly estimated payments. Here is a tool provided by the IRS to determine if you should or not.
Feel free to use that tool to determine the specifics of your situation.
BUT… do the math to make sure you aren’t overpaying! Remember, the goal is to not provide an interest free loan to the government. It’s the same for both the employed and self-employed.
The simplest way to avoid getting hit with penalties, fines, and jail time is to use the IRS’ own W-4 calculator that is linked above. I think that if you use their own device, it would be hard to say that you were intentionally doing the wrong thing.
Here’s the key takeaway: to avoid the problem of giving the government an interest free loan, you probably ought to check your W-4 allowances two or three times during the year to make sure you are on track.
Use the calculator above to stay on track. Add up the math to see what the difference might be.
Hope this is helpful. I’ll keep hustlin’. I hope you will, too!
What do you think? Do you make multiple W-4 adjustments or quarterly estimated payments to make sure you aren’t paying the government too much? Have you ever had issues with any of this? Leave a comment below.