Here’s How Your Income Tax Withholdings Work

March 04, 2019

I was recently given the opportunity to explain tax forms to a bunch of 17-year olds with part time jobs. They were eating pizza in my house when one of the guys asked me to explain how they will pay their taxes when they are adults. I was pleased to hear that one of them was not planning on living with me forever. Here’s how I explained it.

Paying your taxes through work

When you get a job, you fill out something called a W-4, usually on your very first day. This form tells your employer how much money to withhold from each paycheck and your employer sends it to the IRS. At the end of the year you get another form, called a W-2, which shows how much was withheld over the course of the year, along with how much you were paid and some other numbers as well.

I went on to tell them that you will use your W-2 to fill out your IRS Form 1040, which is what you use to file your taxes. At this point I realized that in 15 seconds I had referred to 3 separate tax forms – I was losing them fast and had to change tactics.

An example of how withholding taxes work

I started over, saying, “Let’s say you earn $10 an hour and work 10 hours a week. What would your weekly income be?” They correctly said $100 (with a little eye rolling). I went on: Now suppose you worked 50 weeks a year, what would your annual income be? Proving they have some math acumen, they said $5,000, which seemed like a lot of money to them (to be young again!).

The W-4 is what would tell your employer to keep $5 from your paycheck and send it to the IRS, then they would pay you the other $95 (keeping it simple here). At the end of the year, you would have sent $250 to the IRS.

After the end of the year, you get your W-2, which confirms this information – you earned a total of $5,000 and pre-paid $250 of what you owe to the IRS through your employer. You use that to fill out a tax form called a 1040, where you calculate what your actual taxes due on your income should be.

How you end up owing taxes or getting a refund

If you didn’t have enough withheld, aka your taxes for the year are more than $250, you have to pay the balance by the April 15th deadline. If you withheld too much, aka your taxes for the year are less than $250, then you get a refund for the balance as soon as the IRS receives your form and processes it.

Why not always aim for a big refund check then?

They liked the idea of getting a refund and one asked me why you would just have $10 withheld in order to get more back. I told him that is a very common strategy that some people use who have a hard time saving money. The problem is that you don’t get any interest on that money while the IRS is holding it, whereas if you’d instead just took that extra $5 per paycheck and put it in a savings account, you might have earned a few extra dollars from your bank in interest.

The moral of this story is that when you file your income taxes this year, if you’re due a large a refund or owe more taxes than you want to pay in one lump sum, the best way to avoid that next year is adjust your W-4 withholdings at work.