No one likes to be surprised by an unexpected tax liability. Large refunds are more welcome, but they also mean your client gave the government an interest-free loan throughout the year. You can assist your clients by helping them maintain correct tax withholdings through all their major life changes. Here are some of the most significant life changessignificant life changes that require tax withholding adjustments, plus tips to ensure your clients know how and when to adjust tax withholding.
The most common reasons to adjust federal tax withholdings
The most common reasons for adjusting tax withholdings include:
- Job changes
- Retirement and pension income
- Investment income and capital gains
- Giving birth or adopting a child
- Marriage or divorce
The impact of job changes on withholdings
Changes in income are the most common reason your clients will need to adjust their tax withholdings. If your client starts a new job, they’ll fill out a new Form W-4 with their employer. However, this form doesn’t automatically consider what they made earlier in the year. If the new job pays significantly more than their previous job, they may need to make extra withholding on their W-4 on line 4(C) of the form to make up for the difference.
Your client might also need extra withholding on their W-4 if they have a side job or start doing freelance work. For example, if your client is a graphic designer working for an agency but then decides to bump up their income by doing freelance work for clients on the side, their annual income could increase to the degree that they’ll owe more taxes on April 15 –unless they adjust tax withholdings on their W-4.
If they’re unsure what to put on their new or adjusted W-4, the IRS Tax Withholding Estimator will account for what they’ve earned and withheld earlier in the year and their expected earnings throughout the rest of the year. It will give them an exact estimate of their expected refund or tax liability and make recommendations for how to adjust tax withholding each pay period.
Form W-4 instructs taxpayers to use the Withholdings Estimator if they:
- Expect to work only part of the year
- Have dividend or capital gain income or are subject to additional taxes, such as Additional Medicare Tax
- Have self-employment income or
- Prefer the most accurate withholding for multiple job situations
However, if your client loses their job or is injured on the job and is subject to workers’ compensation or disability income, they’ll likely have an exemption from withholding on their W-4. Workers’ comp, disability, child support, and welfare benefits are examples of W-4 exempt income.
Workers’ compensation is awarded because of a job-related injury or illness and is typically not taxable at the federal level, so it does not require withholding. Similarly, certain disability benefits, especially those paid for through insurance for which the individual has paid the premiums with after-tax dollars, may also be exempt from taxation. This can lead to a lower taxable income for your client, reducing their overall tax liability.
How retirement and pension income may affect your withholdings
Just like income earned from an employer, income from pensions or distributions from other retirement plans is subject to tax withholding, too. That includes distributions from 401ks and many types of IRAs. If your client retires, they’ll likely experience a change in income and will probably want to adjust their tax withholding.
Withholding considerations for investment income and capital gains
Investment income, including dividends and capital gains, is subject to federal income tax and may be subject to state income tax. If your client experiences a large capital gain, like income from the sale of a second home, or sells a substantial amount of stock, they may want to elect extra withholding on their W-4 for the year they receive that additional income. Depending on your client’s income level, they may also be subject to the Net Investment Income Tax (NIIT).
Correctly accounting for investment income is important to avoid underpayment penalties and ensure accurate tax filings.
Adjusting tax withholdings after giving birth to or adopting a child
Welcoming a new child comes with significant tax benefits, namely the Child Tax Credit. Adjusting tax withholdings is usually fairly simple. All your client needs is a new form W-4 that lists their new dependent. Adopting a child comes with additional tax credits that may lead to further adjustments.
Updating tax withholdings after marriage or divorce
Whether your client is getting married or divorced, they should immediately reexamine their withholdings based on their new filing status. Even if a couple gets married late in the year, they’ll still be taxed as if they were married the entire year. They can get ahead by adjusting tax withholdings as soon as possible, even months before they’re married. Again, the IRS Withholding Estimator can help them determine what they should withhold based on their and their future spouse’s income.
Similarly, clients who are getting divorced can adjust their withholdings earlier in the year if they expect to finalize the divorce before the end of the year. If the divorce isn’t finalized by the end of the year, they can technically still file jointly if they prefer. They’ll also need to consider which parent will claim any dependents on their return and make tax withholding adjustments accordingly.
Tips for helping your tax clients make effective tax withholding adjustments
Of course, you can’t help your clients if you don’t know when these changes occur. Unfortunately, many clients may not know that you can help or even that they need to adjust their tax withholdings. Client education can help. Use your social media accounts, emails, and mail advertising to educate clients on major life changes that require tax withholdings adjustments and offer your services in calculating those adjustments. This communication can be as complex as an in-depth email series on situations that require adjustments or as simple as a few lines on a postcard.
If you learn in an in-person meeting that a client is facing one of these life changes in the near future, remind them to adjust their tax withholdings accordingly as soon as possible.
Ultimately, many clients will be able to handle tax withholding adjustments themselves, but even with the IRS Withholdings Estimator, some calculations are tricky, and clients will be grateful for your expertise.
W4 withholdings FAQs:
What is extra withholding on a W4?
Extra withholding on a W-4 form is an optional amount your client can specify for their employer to withhold from each paycheck for federal income tax purposes. This is calculated based on their allowances and filing status. Clients with changes in life circumstances that impact their annual income, like the sale of stock or a vacation home, may want to elect extra withholding on their W-4 to avoid paying additional taxes and penalties on their annual tax return.
Who is exempt from W4 withholding?
To qualify for exemption from W-4 withholding, your client must have no federal income tax liability in the previous year and expect no federal income tax liability in the current year. While no federal income tax would be withheld in such an instance, your client’s paycheck (if they have one) would still be subject to Social Security and Medicare taxes.
How much federal withholding should be taken out?
To help determine how much federal income tax should be withheld from your client’s paycheck, you’ll want to consider the following:
- The number of allowances they are claiming
- Potential income sources other than W-2 employment, like investments or freelance income
- Whether or not they owed taxes the previous year and how much
- The calculation from the IRS Withholding Calculator
By proactively guiding your clients in adjusting their tax withholdings, you can significantly improve their year-end tax experience. Accurate withholding not only prevents unexpected tax bills but also minimizes the need for estimated tax payments. For more information on how to adjust tax withholding and other common tax preparer questions, visit our tax preparer resources online.
