Adjusting your tax withholding could make a big difference in your financial plan. The beginning of a new year is a great time to assess your tax withholding and make any changes necessary.
Your 2021 tax situation is most likely all set. (I say most likely because the deadline to make IRA or HSA contributions for 2021 is April 18th, 2022.)
You may or may not know the extent of your tax refund, or tax owed yet. That depends on how fast you submit your return or get your documentation to your tax preparer. And how prompt they are with filing it on your behalf.
If you do have that information already, great! But, if not, think back to this time last year. Did you get a big refund? Or did you owe a lot of money to the IRS? Or was it pretty close either way?
Should You Adjust Your Tax Withholding?
We do not prepare tax returns. Nor are we CPA’s. But we are well versed in tax planning and believe it is an integral part of a financial plan. If you work with a tax professional this is a great question for them to help you with!
As a general rule of thumb, if you owed the IRS a lot of money last year, then this is an easy YES! Something was not right with your withholdings. Speak with a tax professional as soon as possible. Also you will probably want to speak with your employer and see if you need to submit a new Form W-4.
On the other hand, if you received a large tax refund, do you need to make adjustments?
This is trickier to answer because getting a large tax refund feels great in the moment. Hate to burst the bubble, but a tax refund is actually just a return of your own money to you. You earned the money you receive in a refund, you just withheld more tax than necessary from your paycheck.
A “large refund” is subjective. It means different things to different people. In a recent podcast, Brendan said if it is large enough for you to split apart, then it is too big. Meaning if it is large enough for you to say, treat yourself with half and save the other half, it is too much.
It’s difficult to pin down how much is too much of a refund. But maybe think about it in terms of a paycheck. Is it close to what you receive from a regular paycheck? If so, then yes, I’d consider adjusting your withholdings.
The decision comes down to wanting more cash flow paycheck to paycheck vs. getting a large tax refund once a year. Whatever your choice is, it is important to know that you have options when it comes to your tax withholdings.
When you initially started with your employer, you filled out a Form W-4, which set your tax withholdings based on your initial salary. If you have received a raise, or your compensation structure has changed, the Form W-4 should be updated to make sure you are not basing your withholdings off of incorrect numbers.
If you don’t know what your tax liability will be, you can use the tax withholding estimator provided by the IRS to get in the ballpark.
The ideal tax situation is to get neither a refund, nor owe money. Things change during the year, so it is not a necessity to zero out your tax bill but you should strive to get it as close as possible.
Let’s put some numbers behind this decision so you can see the affects in black and white.
The average tax refund in 2021 was $2,926.
If we take that average and divide it by 24 (paid twice per month) that means you are over withholding $121.91 per paycheck. This adjustment would mean you receive an additional $243.83 in cash flow per month.
I’m not going to say that you should take the extra $243 each month and invest that money into some hot stocks and let your money “work for you” like some other financial “advisors” would say. This isn’t the worst idea, but there are some higher priority financial planning items that should be addressed first. Like paying down debt. Especially debt with a high interest rate attached to it, like credit card debt.
If you are reading this and are inspired to adjust your tax withholding, remember we are already in mid-February. This means you only have 20-21 paychecks left this year, instead of a full 24. Please adjust your numbers accordingly.
If you are completely averse to owing money come tax time, then you probably want to give yourself some cushion and not completely zero out your withholdings. In the situation above, maybe that means withholding an additional $80 from each paycheck instead of the $121.91. That way you will have both more monthly cash flow and won’t be nervous about owing money to the IRS.
Adjusting your tax withholding is a personal decision that depends on your preferences. If you prefer to get a large tax refund, great. Just don’t think of it like a bonus and blow it on something frivolous. It is not a windfall. It is money you earned.
Also if you are married and file taxes as such, you should take your spouses situation into account.
The decision to adjust your tax withholding allows you to be more in control of your month to month finances. Have a plan for where that extra money is going to go. Save it, pay down debt, or invest it in the stock market. These are all better options than having it sit with the IRS for 10 months of the year.