The amount of your money withheld from your paycheck for taxes can be confusing and frustrating. So what are withholding taxes and how do they work? And where does some of your earned income go? These and other questions about withholding tax are answered here.

What are withholding taxes and tax deductions?

On your paycheck stub, you will find several items that represent the money deducted from your paycheck. These tend to fall into two categories: deductions and deductions.

Deductions are taken from your paycheck to cover the amount of income tax and other federal and state taxes you owe. This includes money deducted for Social Security, Medicare, federal and state income taxes.

Deductions are subscribed for your share of social benefits and charitable contributions. For example, you can have a deduction to pay for part of your health insurance plan or your 401 (k) contribution.

So you start with your gross paycheck and then your deductions and deductions are subtracted until you have your take home pay which is the paycheck you take home.

Who determines the federal withholding tax?

For federal income taxes, Social Security, and Medicare, your employer follows a formula provided by the IRS to determine the amount to withhold for taxes from your paycheck. For state income taxes, your employer receives a state form.

In general, the formula for the amount to be withheld for Social Security and Medicare is quite precise. However, with income taxes it is difficult to be so specific; the amount of taxes you owe on your income varies depending on your income as well as the number of tax deductions you can claim when filing.

If, for example, you have a lot of tax deductions, you will end up owing less taxes, which means there will be more money taken from your paycheck than needed. You will get this money back as a refund after you file your taxes the following year.

If, however, you have another job, you may not have withheld your salary enough. You will break even or owe money in this case.

The formulas sin on the side of withdrawing a little more than necessary, as most people should receive a refund in April rather than suddenly having to pay an additional tax bill.

But formulas are not perfect for all situations.

How important is the W-4 form?

Much of the income tax formula comes from the information you provide to your employer when you start your job. On the first day of most jobs, you must complete a W-4 form, known as an employee withholding certificate.

It tells your employer how many people depend on your income, which determines how much tax you pay. These are called “allowances”.

You can claim an allowance for yourself, as long as no one else claims you as a dependent. You can claim an allowance for each dependent other than yourself or your spouse (usually this means children). You can claim zero or one allowance for your spouse. You can also claim an additional allowance if you file your taxes as a “head of household,” which means you are single and have paid more than half the cost of maintaining your house this year.

The more allowances you claim on your W-4, the less money will be taken from your paycheck for federal and state income taxes.

You are allowed to say whatever you want on your W-4 form. All that changes is the amount withheld for taxes from your paycheck. If you put in a lower number of allowances than your actual allowances, they will withhold more from each paycheck and you will have a big refund. If you put in too many allowances, they will withhold less from your check, but you will likely owe money when you file your taxes.

In general, the best thing to do is to be as honest as possible about your Form W-4.

Why shouldn’t I put a high number of allowances on my W-4?

One plan that many people are considering is to simply claim a high number of allowances on their W-4s so that their employer takes very little off their paycheck for income taxes. This means that the net income they receive throughout the year is a bit more, but they will have to pay a tax bill the following April. Some people try to “guess” how many allowances they can claim to reduce their withholding taxes while hopefully covering their entire tax bill.

The downside to this plan is that you will likely end up owing the IRS money out of pocket next April, and the IRS is serious when you owe it money. With 78% of U.S. households living paycheck to paycheck, one extra tax bill can cause a financial crisis in most homes. It’s not worth messing around with these deductions just to have an extra $ 20 or $ 30 on each paycheck; the consequences of not having enough to pay your tax bill the following April can be disastrous.

What about a plan where you put money aside in a savings account every week to pay your tax bill instead of withholding it? On paper, this sounds like a great idea: you put money in a savings account every week, it earns interest, and then you use that money to pay your tax bill. The money left in the account is your immediate “tax refund” plus interest.

Alas, there are problems with this plan.

First of all, you won’t gain much interest this way. With savings accounts paying half of 1% or less in annual interest, you’ll earn at best $ 5 for every $ 1,000 in the account if it’s left in the entire year. It’s not a big deal.

If you invest your money in more aggressive investments, such as risky stocks, you risk losing some of your investment, leaving you without enough money to pay your tax bill.

Second, this plan requires you to calculate the right amount to save each week. If you’re wrong, you might still owe money next April, or you might end up putting in too much, which will essentially bring you back to where you were before you started tinkering with your W-4 allowances.

Third, you must resist the temptation to touch that money. When the holidays arrive, it can be extremely tempting to use a savings account to buy that “perfect” gift for someone or to travel to an exotic location for the holidays. This would leave you with no money to pay your tax bill when the IRS comes knocking on your door in April.

Rather than risking so much to earn so little, let your employer do the work using the IRS formula based on the exact number of allowances.

How to save on taxes

Instead of tinkering with your payroll deductions, focus on maximizing your tax deductions and tax credits. Use reputable tax software that can help you identify any deductions and credits you may be entitled to, or trust a respected tax preparer like H&R Block.

If you’re facing a tax bill, focus on keeping it low rather than playing roulette with your payday deductions.

[This article was originally published on The Simple Dollar in December, 2020. It was updated in November, 2021.]