What is Tax Withholding?
In the early 1900’s there was no paycheck withholding. The individual or family would have to pay their “Tax Liability” at the end of the year in one lump sum. The Government gave us the “opportunity” to have money withheld from each paycheck to go towards our Tax Liability. That way there would not be a big bill that would have to be paid at the end of the year. The Government also “allowed” us to file a tax return by April 15th the following year.
But how do we know how much to expect to pay in taxes for an upcoming year? We can guess, we can run some calculations, but to be honest it is almost impossible to accurately forecast what your “Taxable Liability” will be because everyone’s income is different and everyone’s deductions are different. Let me give a Family-A vs Family-B example:
Two identical houses on the same street have the same number of family members at the same age with the exact same mortgage and interest rate. The fathers are the only income earners and make the same amount of money ($44,544). However, Family-A is saving $4,000 a year in a tax-deductible 401k and uses the flexible savings plan/cafeteria plan at work for $2,000 in medical and dependent care expenses. Family-B does not.
Family-A has pre-tax deductions of $6,000 ($4,000 in 401k and $2,000 in flexible savings plans) so will only need to withhold for $39,444 of net income ($45,444 – $6,000 = $39,444). Their tax liability for 2009 was $5,079 and would need to withhold $195.34 if paid every two weeks.
Family-B, on the other hand, did not have any deductions and will need to withhold for the full $45,444 of income earned that year. Their tax liability for 2009 was $5,979 and would need to withhold $229.96 if paid every two weeks.
To estimate what your tax liability will be I suggest using an on-line calculator such as the one found at H&R Block or DinkyTown.com. I recommend to my clients that they contact me in August to review what has already been withheld and estimate their Tax Liability before the year is over so that we can make adjustments before it is too late.
The next post will address what a Tax Return is.
Read the other articles in this series: