June 26, 2024

Adjusting Your Tax Withholdings: Why, How, and When

Adjusting your tax withholdings can be a strategic move to manage your finances better. Many individuals find themselves either owing a significant amount of taxes or receiving a large refund each year. Both scenarios indicate that your tax withholdings might not be optimized. Here’s why and how you should consider adjusting your tax withholdings.

Why Adjust Your Tax Withholdings?

The goal of adjusting your tax withholdings is to match your actual tax liability as closely as possible. Receiving a large refund means you’ve essentially given the government an interest-free loan of your money throughout the year. On the other hand, owing a large amount could result in penalties and interest. By adjusting your withholdings, you can keep more of your money in your pocket throughout the year.

How to Adjust Your Tax Withholdings

To adjust your tax withholdings, you’ll need to submit a new Form W-4 to your employer. The form guides your employer on how much federal income tax to withhold from your paycheck. The IRS provides a Tax Withholding Estimator tool to help you determine the correct amount to withhold based on your financial situation.

Increasing Tax-Deferred Income

Instead of merely increasing your withholdings, consider increasing your contributions to tax-deferred accounts like 401(k)s, HSAs, and FSAs. Here’s how each can help:

  1. 401(k) Contributions: Increasing your contributions to a 401(k) plan can reduce your taxable income since these contributions are made pre-tax. This not only helps lower your current tax bill but also helps you save for retirement.
  2. Health Savings Accounts (HSAs): Contributions to an HSA are tax-deductible, and withdrawals for qualified medical expenses are tax-free. Increasing your HSA contributions can reduce your taxable income while saving for future healthcare expenses.
  3. Flexible Spending Accounts (FSAs): FSAs allow you to use pre-tax dollars for eligible healthcare and dependent care expenses. By maximizing your FSA contributions, you reduce your taxable income and save on out-of-pocket expenses.


Benefits of Keeping Money in Tax-Deferred Accounts

  • Immediate Tax Savings: Contributions to 401(k)s, HSAs, and FSAs reduce your taxable income, leading to immediate tax savings.
  • Growth Potential: Funds in these accounts grow tax-free or tax-deferred, maximizing your investment growth over time.
  • Access to Funds: While 401(k) funds are generally for retirement, HSAs and FSAs provide more immediate access to funds for healthcare expenses.

Example Scenario

Consider an individual earning $60,000 annually. By increasing their 401(k) contributions from 5% to 10%, they could reduce their taxable income by an additional $3,000. If they also contribute the maximum amount to an HSA ($3,850 for single coverage in 2024), they could further reduce their taxable income. These adjustments could result in significant tax savings while bolstering retirement and healthcare savings.

Review and Adjust Regularly

It’s essential to review and adjust your withholdings and contributions regularly, especially after significant life changes like marriage, the birth of a child, or changes in employment. Use the IRS Tax Withholding Estimator tool periodically to ensure your withholdings remain accurate.

Consult a Tax Professional

Navigating tax withholdings and optimizing tax-deferred contributions can be complex. Consulting with a tax professional can provide personalized advice tailored to your financial situation, ensuring you maximize your tax savings and meet your financial goals.

At Heritage Tax Company, we specialize in helping individuals optimize their tax strategies. Schedule a consultation with us today to learn how we can support your financial health.

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For more information, visit our website: www.heritagetax.co.