Employers use Form W-4, Employee’s Withholding Allowance Certificate to determine the amount of taxes they are required to withhold from their employee’s pay. Employees use their W-4 to let their employers know how much tax to withhold from their income.
After you complete the form, your employer sends the withheld amount from your paycheck to the IRS, along with your name and Social Security Number. Each paycheck withholding is put toward your annual tax bill, which you calculate during tax season each year.
Even if you earn extra income from self-employment or other sources, you can use your W-4 to pay the additional taxes you owe. This will save you from paying a large amount at filing time. Using your W-4, you can keep pay a little bit extra in taxes as you receive outside income.
Withholding too little can lead to back taxes. Withholding too much is not financially advantageous, as you can use that money to spend, save or invest instead of locking it up only to receive it back as a refund later. It is equivalent to giving the government an interest-free loan.
Even though withholding too much is not to your benefit, withholding too little is dangerous. Some taxpayers, especially in times of financial hardship, are tempted to reduce their tax withholdings from their paychecks to take home more money. Even though this strategy may seem beneficial in the short-term, taxpayers may end up with a large tax bill at the end of the year. If they are unable to pay the bill by April 15th, the unpaid taxes grow larger with penalties and interest each month.
The IRS charges a failure-to-pay penalty of 0.5% each month on the amount of back taxes you owe. They also charge interest at the federal short-term rate plus 3 percent for a year. This is compounded daily. Therefore, even if you take home more money from your paycheck, you end up owing more to the IRS. Furthermore, if you do not pay your full tax balance during filing season, the IRS might initiate collection actions to recover what is owed.
The best approach is to calculate and withhold the correct amount of taxes. A big tax refund might be an indication that you are withholding too much and need to review your withholdings.