Is It Better to Withhold Taxes or Not?

Deciding on the right approach to tax withholding involves a careful look at your personal financial landscape, income, and how you prefer to manage cash flow. For some, maximizing take-home pay each month is the priority, while for others, the assurance of not owing a large sum on Tax Day provides peace of mind. This article explores the U.S. tax system’s requirements for paying taxes as you earn, the consequences of failing to meet these obligations, and the methods available to remain in good standing with federal tax authorities.

The Pay-As-You-Go Tax Requirement

The United States operates on a “pay-as-you-go” income tax system, which means individuals are legally required to pay taxes as they earn or receive income throughout the year. This structure prevents a situation where a taxpayer is faced with a single, large tax bill at the end of the year. The principle applies to all forms of income, and the Internal Revenue Service (IRS) provides two primary mechanisms to meet this obligation.

For most people with traditional employment, tax withholding is the most common method. In this process, an employer deducts a calculated amount of federal income tax directly from an employee’s paycheck and remits the funds to the IRS on the employee’s behalf. The amount withheld is determined by the information the employee provides on their Form W-4, Employee’s Withholding Certificate.

The second method is making estimated tax payments. This approach is required for individuals who receive income not subject to withholding, which includes earnings from self-employment, freelance work, interest, dividends, or rental income. These individuals are responsible for calculating their expected tax liability for the year and making payments in four quarterly installments.

Consequences of Tax Underpayment

Failing to pay enough tax throughout the year, either through withholding or estimated payments, can lead to a financial penalty. The IRS can charge an underpayment penalty if you have not met the pay-as-you-go requirements. This penalty functions like interest on the amount you should have paid, calculated for the period the payment was late. The interest rate for the underpayment can fluctuate; for instance, the rate for individuals is 7% for the first half of 2025.

To help taxpayers avoid this penalty, the IRS has established “safe harbor” rules. Meeting any one of these thresholds protects you from the underpayment penalty, even if you owe money when you file your return. The first safe harbor is owing less than $1,000 in tax after subtracting all your withholding and refundable credits.

For those with a larger tax liability, there are two other primary safe harbor provisions. The first is paying at least 90% of the tax owed for the current year. The second is to have paid at least 100% of the tax shown on your prior year’s tax return. This threshold changes for higher-income individuals. If your Adjusted Gross Income (AGI) on the previous year’s return was more than $150,000 (or $75,000 for those married filing separately), you must pay at least 110% of the prior year’s tax to meet the safe harbor requirement.

Information Needed to Adjust Withholding

To accurately adjust your tax withholding, you must gather specific financial and personal information before completing a Form W-4, Employee’s Withholding Certificate. This form instructs your employer on how much federal income tax to withhold. The first step involves providing personal details, including your name, address, Social Security number, and your chosen tax filing status.

The form then requires you to account for more complex financial situations. Step 2 is for individuals who hold more than one job or are married to a spouse who also works. Step 3 is where you claim dependents, which reduces the amount of tax withheld. You will need to know the number of qualifying children under age 17 and the number of any other dependents you plan to claim.

Step 4 allows for other adjustments to fine-tune your withholding. This includes adding other income you expect to receive that is not subject to withholding, such as interest or retirement income. You can also account for deductions you plan to take beyond the standard deduction. Finally, you can specify an amount for any extra tax you want withheld from each paycheck. The IRS provides an online Tax Withholding Estimator tool, which is an accurate way to determine the figures for these fields.

Submitting Withholding Changes and Making Estimated Payments

Once you have determined the correct withholding amounts and completed your Form W-4, the next step is to submit it to your company’s human resources or payroll department. Keep in mind that the changes to your paycheck may not be immediate. It can often take one or two pay cycles for the new withholding instructions to be processed and reflected in your take-home pay.

For individuals who pay estimated taxes, the process involves direct payments to the IRS. You can pay directly from your bank account using IRS Direct Pay or enroll in the Electronic Federal Tax Payment System (EFTPS), a free service provided by the Treasury Department. The IRS2Go mobile app also offers a convenient way to make payments.

If you prefer not to pay online, you can mail a check or money order to the IRS, but you must include a payment voucher from Form 1040-ES, Estimated Tax for Individuals. Regardless of the method, these payments are due in four quarterly installments. The typical deadlines are April 15, June 15, September 15, and January 15 of the following year.