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7 Reasons to Consider Adjusting Your Federal Tax Withholding Right Now

By Sean Williams – Sep 24, 2016 at 6:41AM

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Adjusting how much tax the IRS takes out of each paycheck could improve your financial outlook.

Image source: Getty Images.

Taxes may be the furthest thing from your mind at the moment, with Tax Day well over six months away, but a subtle tax change now could have a big impact on what happens when April 15 rolls around.

The easiest way consumers can influence their federal income taxes is by making changes to their W-4. In layman's terms, we're talking about changing your federal tax withholding allowance, or what you allow you the federal government to withhold from each of your paychecks. The government doesn't determine how much it withholds from each paycheck; that's up to you to figure out and let your employer know. If certain changes or life events happen throughout the year, it could be worthwhile for you to consider adjusting your tax withholding in order to improve your financial outlook.

Here are seven good reasons why you might consider adjusting your federal tax withholding right now.

1. You're on track for a big refund

Generally speaking, most taxpayers love getting a refund from the Internal Revenue Service. Unfortunately, getting a fat refund is often a poor use of your cash.

Though a tax refund is a good way of forcing people with little financial discipline and/or no budget to save money, the money being saved isn't earning taxpayers any interest. Think about all of the various ways you could put your money to use now instead of many months from now. You could begin investing for your future, or perhaps pay down credit card debt, which is only going to compound with interest by the time April 15 approaches. Adjusting your tax withholding allowance now could beef up each paycheck throughout the remainder of the year -- and at worst put a few extra dollars in your pocket for the upcoming holiday season.

Owe too much and you could be hit with an underpayment penalty. Image source: Getty Images.

2. You're on track to owe more than $1,000

On the flipside, about 20% of tax filers wind up owing money to the IRS in any given year. Owing money actually isn't a bad thing, since it means the federal government didn't get to hang on to an interest-free "loan" from you during the course of the year.

However, taxpayers who will owe money need to be careful they don't owe too much; otherwise, they could face a penalty for underpaying. If what you're estimated to owe is less than $1,000, then give yourself a pat on the back for some pretty good tax planning because there's only a slim chance you'll be hit with an underpayment penalty. But, if you're on track to owe more than $1,000, you're considerably more likely to be subject to that aforementioned penalty. Given that it's September, it's not too late to increase your withholding or make an estimated tax payment to reduce your estimated underpayment to a three-digit figure if you expect to owe $1,000 or more come April 15.

3. You bought a house

Did you purchase a house or condo this year? If you did, you could be primed for some juicy tax deductions come April. Homebuyers typically get the luxury of deducting what they pay in mortgage interest, as well as what they've paid in mortgage points in order to obtain their loan. The mortgage interest deduction is particularly helpful for new homebuyers since they'll be paying a lot toward interest and not so much toward their loan's principal in the early years.

If you've purchased a home or condo, you may want to consider reducing how much tax the IRS is withholding when taking into account these expected deductions.

Image source: Pixabay.

4. You got married or divorced

One of the easiest ways to be surprised come Tax Day is to fail to take into account the advantages or disadvantages of getting married or divorced, as it relates to your tax situation.

Being married and filing your taxes jointly with your spouse usually leads to a number of added tax breaks and deductions, such as the ability to claim two personal exemptions. If you've recently been married, there's a decent chance your tax liability could drop, meaning an adjustment to a lower withholding might make sense.

On the other hand, getting a divorce thrusts married filers back into single filer status, removing some of the deductions they may have become accustomed to. For divorcees, it may be wise, after using the IRS's withholding calculator, to consider increasing what's taken out of each paycheck by the federal government.

5. You (or your spouse) got a second job

Another smart reason to consider adjusting your tax withholding allowance is if you or your spouse get a second job or start a home business.

In general, adding income from any secondary job means your tax liability is going to go up. Many employers will require you to fill out a W-4 that'll allow you to choose your withholding allowance. But if you start a home business, or aren't required to fill out a W-4, you'd probably be wise to consider increasing your tax withholding with your primary employer to take into account the added income being generated from your side job.

Likewise, if your spouse gets a second job, it'll almost certainly impact how much you'll owe in taxes as a couple, possibly necessitating an adjustment to either -- or both -- of your withholding allowances.

Image source: Flickr user Missy Schmidt. 

6. You've been unemployed part of the year

At the other end of the spectrum, if you spent part of the year unemployed, chances are good that you've probably overpaid the federal government during the course of the year (remember, about four in five people get a refund each year).

If you've taken on a new job, it would be wise to take into account your loss of income during the time you were unemployed when factoring in your new tax withholding. More than likely, after using the IRS withholding calculator, you'll be able to reduce your withholding and increase your subsequent paychecks for the remainder of the year.

7. You've had a new addition to the family

Lastly, having a baby or adopting a child could lead to some game-changing tax breaks, including the allowance of a dependent, as well as certain types of credits (i.e., the Child Tax Credit and Child Care Tax Credit).

If you choose not to adjust your tax withholding in the year you have a baby or adopt a child, chances are good that you'll wind up with a bigger refund than expected. But keep in mind that if you're getting a big refund, the federal government is getting to hang on to your money for free! In short, if you've added a new bundle of joy to your family, consider how those tax breaks could influence your tax liability, and adjust your tax withholding accordingly.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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