Tax withholding from your paycheck is the state, local and federal governments' way of ensuring you have paid your tax obligations before the end of the tax year. Your goal is to have enough money withheld from your checks to pay your taxes, while still taking home as much of your hard-earned dollars as possible. Understanding the advantages and disadvantages of having enough taxes withheld from your paycheck is an important step in the process.
Pay As You Go
The United States tax payment system is a pay-as-you-go system. This means you are obligated to pay the taxes on your income as you earn the money. Your employer helps with this process by collecting your taxes via payroll, and submitting them to the proper government agency. The amount of tax money withheld from your check is based on the paperwork you filled out when you started your job or at the beginning of each year. For the federal government, you would complete a form W-4. You might need to complete additional forms for your State and local governments.
The biggest advantage to having enough taxes withheld from your paycheck is you do not have to come up with a lot of money at year-end to pay the taxes you owe. You can also ask your employer to withhold additional money to cover the tax owed on other income, such as self-employment earnings or gambling winnings. This prevents you from needing to file estimated tax payments quarterly during the year to keep up with your tax obligation. If you overpay your taxes, at year-end you can apply for a refund of the overpaid amount. Many people find this feature useful as a savings plan to pay for large purchases.
Having more taxes withheld from your paycheck than you need to pay your taxes reduces the amount of money you have available to pay for living expenses and entertainment. The amount you overpay in taxes does not earn interest from the government unless the government tax agency fails to send your refund in a timely manner. You may find it more beneficial to put the money into a savings account, invest the over-payment into paying off high-interest credit card debt or start up a mutual fund account.
While having more taxes withheld from of your check than necessary comes with disadvantages, not having enough funds withheld to cover your tax bill each year can get you an underpayment penalty. Generally, a taxpayer who owes more than $1,000 in tax debt after subtracting withheld tax money and tax credits, or a taxpayer who has paid less than 90 percent of his owed taxes for the year is in danger of incurring a tax penalty.