Time for a paycheck checkup

March 15, 2022

When I was quite young, I remember my grandfather telling me that there are only two things certain in life: death and taxes. He meant it as a jest, but in a more serious vein, I would like to propose a third candidate for that group: the increasing complexity of our tax regime.

Despite various attempts to reform and simplify, our tax code remains a complex beast, full of credits and phase-outs with self-adjusting schedules that change year-by-year. Keeping up with these changes can be difficult. However, failing to keep up can lead to some unfortunate surprises, including IRS penalties. That is one reason why the IRS encourages individuals to do an annual paycheck checkup. In fact, they have a website (www.irs.gov/paycheck-checkup) dedicated to helping you do this self-check. Of course, their website is not meant as tax advice—you should see a real-life tax professional for that sort of thing. But the IRS website can help you determine if you are withholding enough from your paycheck to keep yourself out of hot water with the Feds.

If you are a two-income family or if you work multiple jobs, you should check your paycheck withholdings at least once a year. According to the IRS, households reporting multiple incomes, whether from multiple earners or from multiple jobs, tend to miss more often on their withholding than other taxpayers. Here are some other clues that might indicate your withholding level needs to reviewed:

  1. Did you owe tax when you filed your return last year?

  2. Did you have a refund that was significantly different than you expected?

  3. Did you experience a major life event in the past year such as marriage, childbirth, adoption, loss of a dependent, or buying a home?

  4. Did you see a significant change in your household income?

In addition, there may be more subtle aspects of your financial situation that could warrant an adjustment to your withholding. For example,

  1. Do you have children and claim credits, such as the Child Tax Credit?

  2. Do you have older dependents?

  3. Do you typically itemize deductions?

  4. Did you work only part of the year?

  5. Did you receive unemployment compensation at some point during the year?

  6. Do you have significant investment income (i.e., investment income greater than $10,000)?

  7. Did you have a high income? (Note that “high income” is a subjective term. In some publications, the IRS deems incomes greater than $100,000 to be “high income.”)

  8. Do you file a complex return showing income from multiple sources, including business pass-through income, passive income or losses, etc.? Your return could also be considered complex if you owe alternative minimum tax or certain other taxes or if you have long-term capital gains or qualified dividends.

If any of these conditions apply to you, you should take time to do the paycheck checkup. The IRS levies penalties for underpaying income taxes. Penalties generally amount to 0.5 percent of the underpaid amount but could be as high as 25 percent. To avoid penalties, you need to pay either 100 percent of last year’s tax or 90 percent of the current year’s tax, including both salary withholding and estimated tax payments.

The IRS’s Paycheck Checkup website includes a link to their withholding calculator. It is very thorough and will give you a pretty good sense of where you stand. If your situation is subject to change during the course of the year, you can run your calculator as frequently as needed to make sure your withholding is on track for the year. Note that the standard withholding calculator may not fully capture your situation if you file a complex return. In that case, it would probably be better to ask your tax professional to run a paycheck checkup for you.

Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to steve@montereypw.com.