Navigating Your Paycheck: Understanding Tax Withholding and Actual Tax Owed
It can be tough to understand how tax withholding works on your paycheck. Sometimes, people get a surprise at tax time and owe more than they thought, even if they claimed zero exemptions. It’s not as easy as it seems. Your paycheck can include not just salary but also things like commissions, bonuses, and equity such as Restricted Stock Units (RSUs). Each of these potentially have different tax withholding rates. When the withholding rate is different from your actual tax rate, it may lead to a tax surprise. Understanding the distinction between tax withholding and actual tax owed is important. Let’s break it down.
Income tax withholding is the portion of your income that your employer holds back each pay period to cover your estimated taxes. The amount withheld depends on the information you provided on your Form W-4. These funds are then sent to the IRS on your behalf. In essence, withholding is like making ongoing mini tax payments throughout the year.
However, the key is that withholding on your paycheck is simply an estimate. The actual tax you owe could be more or less depending on a variety of factors, such as your total income, deductions, credits, and the current tax laws.
Different Income, Different Withholding Rates
When you receive wages or a salary, the withholding is usually straightforward. But when other forms of income come into play—like commissions, bonuses, and RSUs—the tax withholding rates can vary.
For instance, bonuses and RSUs are often subject to supplemental withholding rates, which may be different from the regular income tax rates. When there is a difference, this is what leads to the tax owing or refund.
The Importance of Tax Projections
Given the complexities and the potential for under or over-withholding, it’s important to periodically check your withholding throughout the year, especially if you have multiple sources of income. This is where tax projections come in.
As financial advisors and tax professionals, we can assist our clients by asking them to provide us with year-to-date pay stubs and any other income activity. Using this information, we run a tax projection to estimate the actual tax for the year. If it looks like the withholding will fall short of the tax liability, we can then advise on making estimated tax payments to make up the difference and avoid a big bill (and potential penalties) at tax time.
Navigating taxes can be daunting. Understanding the difference between withholding and actual tax owed, and regularly checking in with your tax professional can help ensure you stay on track and avoid any unpleasant surprises come April. Reach out to our team for more financial strategies and tax support.
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