The simplest of dance moves is the head nod -- it'll get you through any wedding without embarrassment. And the simplest of tax moves? Reviewing your W-4 annually to get through any tax year without penalties for underpayment.
A 2018 report from the Government Accountability Office estimated that 30 million U.S. taxpayers would owe taxes in 2019 due to underwithholding. The stark warning came after legislators pushed out the Tax Cuts and Jobs Act enacted in December 2017. The tax law changes affected withholding tables and left many taxpayers inadvertently giving too little to Uncle Sam with each paycheck.
Even in the absence of sweeping tax reform, underpaying during the tax year is a risk we all face. Job changes in your household can push you into a new tax bracket, and changes at home can alter your filing status. If you don't update your paycheck withholding to address the new situation, you might be left with a large tax bill, plus some penalties, when April 15 rolls around. That's why it's a smart move to update your W-4 with your employer periodically.
How penalties for underwithholding work
You'll incur an underpayment penalty when you pay less than 90% of your tax liability during the tax year. The standard penalty is 3.398% of your underpayment, but it gets reduced slightly if you pay up before April 15. So let's say you owe a total of $14,000 in federal income taxes for 2020. If you don't pay at least $12,600 of that during 2020, you'll be assessed the penalty. That's tricky because most of us don't know our total tax bill until we complete our return, which is after the close of the tax year.
You can plan ahead by basing 2020's withholding on your 2019 tax bill. This is an option because the IRS will waive the underpayment penalty if you paid at least 100% of your tax liability from the prior year. The threshold goes up to 110% for married filers with an adjusted gross income (AGI) over $150,000 and single filers with an AGI over $75,000. You might also be eligible for a waiver if you retired or became disabled in the underpaid tax year or the prior one.
When to update your W-4
If you already suspect you're underpaying, the time is now to review your W-4. Other situations that should prompt a W-4 review include:
- You get married or divorced.
- You have or adopt a child.
- You or your spouse loses a job.
- You or your spouse takes on a second job.
- Your spouse starts a new job.
- You purchase a home.
- You or your spouse starts a side hustle.
Accounting for second jobs and side hustles on your W-4
The 2020 W-4 does incorporate a worksheet to address withholding when you and your spouse have two or three jobs between the two of you. If you each have one job and make roughly the same amount, you can check the box in Step 2 (c) of both W-4s. Alternatively, you can use the Multiple Jobs Worksheet to calculate additional withholding based on your situation. Note that you should complete that worksheet only for the highest-paying job. The same goes for claiming dependents and other adjustments -- these go on the W-4 for the highest-paying job only.
Taxes on self-employment income are trickier to handle for two reasons. First, there's obviously no separate W-4 or withholding for that income. And you'll owe self-employment tax plus regular income tax. The self-employment tax covers your Medicare and Social Security taxes, which are assessed at 15.3% of your self-employment income.
You can estimate your taxes from your side hustle and make quarterly tax payments with Form 1040-ES. But you can also pay your estimated self-employment tax through the paycheck you get from your day job. You do this by adding a dollar value to the extra withholdings line at Step 4(c) of your W-4. This strategy is explained in more detail below.
How to adjust your W-4 withholdings
Whether you have a side hustle or not, there is an easy way to estimate your annual tax liability and then adjust your W-4 to match. Lean on the IRS tax withholdings estimator to do the heavy lifting for you. To use the estimator, you'll need recent pay stubs for you and your spouse. You'll also need documentation on your other sources of income, including self-employment income, unemployment payments, pensions, dividends, interest, and distributions from your retirement plans.
After you walk through the estimator's prompts, it will display your expected tax withholding for the year, along with estimated tax liability and underpayment, if any. If your results show an expected underpayment, the estimator tells you exactly how to update your W-4 to address it. You can even print out a prefilled W-4 to sign and take to your employer.
That W-4 will address your projected underpayment by specifying a dollar amount for additional withholding. Make sure you adjust your monthly budget accordingly, as that extra withholding will reduce your net pay.
Sidestepping underpayment penalties
Unfortunately, the IRS won't accept a cool head nod in response to a tax underpayment. If there's a possibility you underpaid in 2019, file your taxes and pay what you owe as soon as possible -- that will keep your penalty to a minimum. Then run through the IRS tax withholdings estimator, print out the resulting W-4s, and give them a quick review. If everything makes sense, turn them in to your employer right away. That should keep you in Uncle Sam's good graces, as long as you repeat the process whenever your family or job situation changes.