Much to my surprise the same topic has come up several times already this year in my office. A client is getting a big bonus or commission at work and the Man is going to take most of in taxes. My client’s co-workers are tell them to make that one paycheck “tax exempt” or “you’ll get it all back at tax time” and they just don’t know what to do. So, Jane, what do I do?!?!
First of all, do you work in a tax accountant’s office? Because if you don’t, stop listening to your co-workers. Everyone thinks they know how things work, but they don’t, because no one really knows all about the in and outs of your tax return except you (and me).
So here’s what I wrote up for a client and am now sharing with the universe!
Ok, I might overexplain here, so forgive me. I just want to be a clear as possible!
Your federal tax withholding is basically dependent on your total income for the year, but it adjusts up as the year goes on and you make more money. (At least this is the way it worked before the new tax law screwed everything up.) So it all goes merrily along until you get a big, unexpected bonus. Then the system kinda freaks out and withholds tax on that bonus at the top tax rate, which is generally in the mid 30%s, and once we add on state and local you are indeed coming closer to 40% total.
(I do not think this is something that is legally required, as evidenced by how people try to get out of it, but I’ve seen it over and over again and experienced it directly when my husband worked on commission.)
The theory is that while your regular salary will only be taxed at, say 15%, you might get another bonus and another bonus and then all of sudden you are going to jump a tax bracket or two or three and be in big trouble, so we are going to withhold as much as possible to prevent an underwithholding penalty.
So if people know that this bonus is the only one they are going to get, or they are planning to quit the next day, or whatever else people are convinced they are going to KNOW FOR SURE, they KNOW they are not going to break into a higher bracket so they really don’t want all that money withheld only to get it back when they file their tax return a year later.
That’s why your coworkers want to go “tax-exempt” for one pay period. Now, I don’t know if they are going to go tax exempt on just one regular paycheck or just the bonus, or both or what. But they are betting that in the end they really won’t be in that higher bracket so the withholding will have been for nothing (I have my own opinions on this!).
The problem is that everyone thinks their tax situation is just like everyone else’s. I cannot tell you how aggravating it is to hear, “Well, my neighbor makes the same amount of money I do and he got a huge refund this year, so you must be doing my return wrong.” (Side note, if that a**hole shows his face in my office this year he is gonna be sorry.) The coworker who gets the $20,000 bonus who is a single parent with 12 children is not going to be paying that tax. The guy who never mentions that he also has a huge investment portfolio and also a side gig as an international hand model is totally gonna be in that higher bracket and pay the tax on that bonus.
I am financially very conservative. I would have the tax withheld and forget about it and then maybe get a pleasant surprise at refund time. But for some people that would cause them to break out in hives. They would rather risk owing and have the money in their pocket, or maybe they really do need it to pay for something more important (like food). The best advice I can give you is do what you are comfortable with, and then at the end of June come visit me with your most recent paystub and we will run some projections to see how things are coming out. Then if it looks like you are going to owe you have time to make adjustments or start putting some cash back for tax time.
By the way, it took me forever to figure out that in this modern world lots of people can pop into their payroll account and change their withholding back and forth at will. This blows my mind. The last time I had a real job there was no online anything and I think I actually got paid in acorns.