Are You Overpaying on Your Taxes?

The word taxes bring shudders to many people. However, taxes aren’t necessarily a bad thing. On some level, your taxes fund services that benefit the public such as Social Security and Medicare. Paying too much, however, amounts to an interest-free loan to the government, leaving you with a higher burden than necessary. We highlight some common reasons for overpayment and how to avoid them.

Key Takeaways

• Withholding taxes are deducted from your paycheck by your employer and include federal, state, local, and FICA taxes.
• Your withholding is excessive if you receive a large tax refund, meaning you’re overpaying in taxes with each paycheck.
• You may want to consider adjusting the withholding amount with your employer.
• Life events like marriage, adding a dependent, or a job change may require adjusting your withholding.
• The ideal tax refund is exactly zero, meaning you didn’t “loan” money to the IRS interest-free.

What Is Withholding Tax?

Withholding tax is the money your employer deducts from your paycheck. The amount withheld depends on two factors:

• Your income
• Form W-4, which tells your employer how much to deduct based on your marital status, dependents, and allowances

Withholding covers several types of taxes, including federal, state, and local taxes. Your employer also withholds Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare.

A Clear Sign You’re Overpaying

The most obvious sign that you are paying too much tax is the size of your refund. The average refunds early in the filing season tend to be just over $3,000 as the people who expect to get money back from the Internal Revenue Service (IRS) tend to file their returns early.

While filing early can be beneficial, especially when other life events take priority, you may be overpaying. Life changes such as expecting a child, a job loss, or a dependent moving in can occur before you have time to adjust your withholding with your employer.

Important

If you regularly receive several thousand dollars back from the IRS, you are likely overpaying taxes throughout the year.

Reasons to Adjust Your Withholding Tax

Here are common life events that can impact your withholding amount:

• Marriage: A spouse’s income affects your household tax bill. If your spouse is a dependent, you may need to reduce your withholding. Divorce also requires an update, particularly when dependent children are involved.
• Addition to the Family: The birth or adoption of a child reduces your withholding since you’re adding a dependent.
• Changes in Income: If you aren’t accounting for income from non-wage sources or a second job, you might end up owing more taxes. Conversely, if income from a side business drops, you should reduce withholding.

Some payroll departments will prompt your W-4 if they are aware of these life changes. For most people, however, it up to you to provide the updated paperwork.

Use the IRS Tax Withholding Estimator to determine how much tax should be withheld from your paycheck. You’ll need your paystubs, information from any other income you receive, and your most recent tax return to use the tool.

When Should You Adjust Your Withholding?

It’s best to adjust your withholding before you expect your tax return. The longer you wait to make adjustments, the greater the opportunity cost. If you anticipate large tax credits or deductions, such as education credits, dependent care credits, or charitable giving deductions, update your withholding earlier to avoid overpaying.

Instead of waiting for the return, use the IRS’s withholding calculator to model different scenarios and determine the right amount to withhold.

Reasons to Intentionally Overwithhold

There are certain situations where people might opt to withhold more money from their paychecks intentionally, such as:

• Saving for a large refund: Some prefer overwithholding to ensure a larger refund, which acts as forced savings. If the money isn’t in their bank account, it’s harder to spend.
• Variable income: People with fluctuating income or multiple income streams may overwithhold to prevent an unexpected tax bill. It can be challenging to accurately predict annual earnings in these situations, and having more taxes withheld can act as an insurance policy.
• W-2 and 1099 income: If you have both a full-time job (W-2) and part-time self-employment (1099), you may intentionally have more withheld from your W-2 job to compensate for taxes not withheld from your 1099 income.
• Penalty avoidance: If you’ve been penalized for underpayment in the past, you may choose to overwithhold to avoid penalties. In most cases, taxpayers who owe less than $1,000 or have paid at least 90% of their taxes leading up to their return will not be assessed a penalty. However, the IRS may impose a penalty (which can be waived) should you fall below certain thresholds.

Some may also choose to overwithhold if they expect to exceed the IRS’s gift tax exemption. For instance, in 2024, gifts over $18,000 could trigger gift tax obligations.

Warning

There is a list of penalties you may incur as part of your tax return. Take note that the IRS does charge interest on penalties.

Disadvantages of Withholding Too Much Tax

Overpaying taxes and having too much tax withheld has several disadvantages:

• Interest-free loan to the government: By overpaying, you’re effectively giving the government an interest-free loan. Your money sits with the IRS until you request it back via your refund.
• Inflation impact: The value of money declines over time, so a $1,000 refund may not hold the same value due to inflation. You could also have invested that money, potentially growing it over the year.
• Psychological reliance on refunds: Relying on a large refund can be risky. If it doesn’t materialize in one year, you may be left scrambling to make up the difference.

Why Should I Adjust my Withholding Tax?

You should adjust your withholding whenever there’s a significant life event, such as a change in marital status, a new dependent, or a job change. Adjusting your withholding allows you to either increase or decrease the amount withheld from your paycheck, affecting your tax refund or liability. Paying more through withholding reduces your take-home pay but results in a refund. This means you’re essentially providing an interest-free loan to the IRS for an entire year. On the other hand, paying less may leave you with a tax bill at the end of the year.

Who Is Exempt From Withholding?

If you work, you will have to pay taxes on any income that you earn. But you may qualify for an exemption from withholding as long as you “have had no tax liability for the previous year and must expect to have no tax liability for the current year.” This means that the total tax calculated on Form 1040 is less than the total amount of refundable credits you claim. You must inform your employer not to deduct withholding taxes using Form W-4. A new form must be completed each year. Keep in mind that your employer will still withhold FICA taxes, which are used to fund Social Security and Medicare.

How Will Any 401(k) Contributions I Make Impact My Withholding Tax?

Contributing to a 401(k) can lower your taxable income, reducing the amount of tax withheld from your paycheck. Not only does this help save for retirement, it can also decrease your overall tax liability.

The Bottom Line

No one likes to pay taxes, so it may seem like a big win when you see a big tax refund. In reality, a large refund means you’ve overpaid taxes throughout the year, essentially giving the IRS an interest-free loan.

To avoid overpaying, adjust your withholding whenever you experience a life event like marriage, the birth of a child, or a job change. Regularly review and update your W-4 to ensure you’re withholding the correct amount. However, overwithholding may make sense in some there are situations, such as saving for a large refund or avoiding penalties on estimated taxes.