Prepaying Taxes: Withholding and Estimated Payments

Although the government insists you prepay what you owe in tax, the IRS generously provides two methods for doing it: withholding and estimating. Your problem is how to be sure you’re paying the right amounts.

Withholding makes your life easier, even if you’d rather not have to share your earnings with Uncle Sam. The IRS doesn’t set the amount that’s withheld from your salary or wages. Your employer determines your withholding from the information you provide on IRS Form W-4. You fill out a W-4 whenever you begin a new job, and you can update an existing one at any time to increase or decrease the amount that’s being taken out.

Dealing with W-4

To complete the W-4, you must:

• Provide your name and Social Security number
• Indicate whether you’re single or married or head of household
• Complete sections 2 through 4 if they apply to you—for example if you have income from more than one job or claim dependents

Sound easy? On the surface, it is. But there’s a catch. What you’re trying to do is to come as close as you can to matching the amount withheld with what you’ll owe in taxes. That way you avoid the prospect of a penalty for underpaying and the pointlessness of overpaying.

Virtually the only wiggle room you have is in Step 4, Other Adjustments. If you have income from investments or other non-job sources, you can indicate you want more withheld to cover the tax you’ll owe. That should help to reduce the underpayment problem. You’ll have to provide an estimate on line 4a of the dollar amount you expect to receive. One place to start is with the amount those sources provided in the previous tax year.

Or, if you anticipate that you’ll itemize deductions because the total will be higher than the standard deduction to which you’re entitled—perhaps because you’ll be deducting mortgage interest and state income taxes—you can reduce your withholding. In this case, you use the Deductions Worksheet provided with the form to calculate the amount you enter on line 4b.

But if you discover in April, when you file your return, that way too much or too little has been withheld, you need to make some changes to your W-4.

Multiple Jobs

If you have more than one job, or if both you and your spouse are working, amounts will be withheld from multiple paychecks. The IRS, in the current version of form W-4, has simplified what once had the potential to result in serious miscalculations. In Step 2 of the form, you can choose among three alternatives for determining the most accurate withholding: using an estimator, completing a worksheet, or simply checking a box if there is a total of only two jobs.

In addition, the form itself provides helpful tips that you can rely on to end up with the most nearly correct result.

Paying estimated taxes

If you’re self-employed or a freelancer, either full-time or in addition to working as an employee, the IRS expects you to estimate how much tax you’ll owe for the year and pay part of it each quarter, in April, June, September, and January. You use Form 1040ES, “Estimated Tax for Individuals,” to figure your estimated tax and make your payments.

The first payment is due for the first quarter in which you have taxable income. You can pay everything you expect to owe then, in a lump sum, or you can spread what you owe over the rest of the year. The usual way is to divide the total you’re prepaying by four (or however many quarters are left) and pay it in equal amounts. That’s fine if your income is fairly regular and predictable. But you may have a problem if it’s not—something that’s fairly common when you work for yourself.

The solution may be to recalculate the tax you owe each quarter to find the minimum due on each of the remaining dates. You can get IRS Publication 505, “Tax Withholding and Estimated Tax,” or you can consult a tax adviser. In fact, you may want to find one who specializes in clients with self-employment income.

Double Identity

If you’re paying estimated income taxes, perhaps because you’re a freelancer or self-employed, you have to pay Social Security and Medicare taxes, called self-employment taxes, yourself. The Social Security that’s due in most years is 12.4% of your earnings up to the annual cap. You must also pay 2.9% of your total earnings for Medicare, with no cap.

Those are twice the percentages that your employer withholds if you have a job. That’s because you’re paying two shares—yours as employee and yours as employer. The consolation is that you can deduct half the total, equal to the employer’s share, as an adjustment to income on your tax return. That reduces your AGI, and your taxable income.