[IMGCAP(1)]All across America, hard-working people receive their personal income tax returns and wonder why they still owe money at tax time.

For some the answer is that they sacrificed adequate withholding to receive more money with each paycheck. For other dual income earners, both singles and married couples, they believe they are withholding the correct amounts based on their earnings, but they still owe money. There is a blind spot in their calculations. This article will explain the blind spot and how it can be fixed.

The purpose of IRS Form W-4, Employee’s Withholding Allowance Certificate, is to allow one’s employer to “withhold the correct federal income tax from your pay. Consider completing a new Form W-4 each year and when your personal or financial situation changes” (emphasis added). Every employer asks an employee to complete this form when they begin a new job. It is easy to remember to change one’s elections when a family grows or contracts or marital status changes. It is not an easy form to complete if one is trying to cover oneself for proper withholding.

Most people do not consult Publication 505, Tax Withholding and Estimated Taxes, a scintillating 61 pages designed to help one calculate and adjust one’s withholding. As a result, most people complete the W-4 with the same elections each year. They do not contemplate the impact of additional sources of income into the family unit, whether from a second job, a new job, or the employment of a spouse.

Here is the catch:

The withholding tables assume that the individual being paid is the only wage earner in the family unit.

To answer the question, “Why is this big deal?” we must look at how taxes are calculated. To keep things simple, we are looking only at the basic tax rates and earned income.

We are ignoring the impact of unearned income (e.g. interest, dividends, stock transactions, etc.) as well as exemptions and deductions. The tax rates are graduated from 10.0 percent on up to 39.6 percent. The different levels of tax are charged only to the amounts that fall within that tax bracket bucket. Someone in the 28 percent tax bracket is only paying 28 percent on the taxable income that is above the amounts that exceed the top end of the 25 percent bracket. If a family unit only has one wage earner who has only one job, then the tax withheld should be appropriate (assuming the W-4 was completed properly).

The troubles begin with the second source of earned income. Remember, the tables assume there is only one wage earner. Now you have two incomes being applied to the same tax bracket bucket, filling each more quickly. Consider a couple who each earns $125,000. They have a combined $250,000 of earnings. The tax on $125,000 for a married couple is $22,962.50 (($18,150 x 10%) + ($55,650 x 15%) + ($51,200 x 25%)). Following the W-4 instructions, each individual would have $22,962.50 of withholding for a combined total of $45,925 of withholding. But the income taxed is on the couple’s married filing joint tax return of $250,000. The tax on that amounts is $58,404.50 (($18,150 x 10%) + ($55,650 x 15%) + ($75,050 x 25%) + (78,000 x 28%) + ($23,150 x 33)). The couple would still owe $12,479.50 with their tax return. Individuals could run into this same problem if they switched jobs during the course of a year. It also applies to people who work multiple jobs at once. 

So how do you address the problem for a client and avoid getting them buried at tax time? Be cognizant of each time they, or someone in their family group, has a new source of earned income. Be aware of the vertical impact of the tax brackets. Understand the need for the second or third source of earned income to assume a higher starting rate of tax and withhold accordingly.

Steven P. Kessler is a partner at Kessler Orlean Silver & Co. PC in Deerfield, Ill. He can be contacted at spkessler@koscpa.com.

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