Wednesday, June 8, 2022

Ten Tips for Tax Withholding on Multiple Income Streams

It is not uncommon for American taxpayers of all ages to have multiple streams of income. Young adults working in the gig economy may have income from a variety of consulting contracts or from a full-time job and “side hustles.”


Many older adults also have multiple income sources including Social Security, a pension, full-or part-time work or self-employment, withdrawals from retirement savings (including taxable required minimum distributions or RMDs), and interest, dividends, and capital gains on investments. Roth IRA conversions also produce taxable income at any age.


A big concern of people with multiple income streams is adequate tax withholding. Nobody want to pay the IRS tax underpayment penalty, which is 0.5% of the amount owed for each month or partial month of unpaid taxes.

Below are ten tax withholding tips for taxpayers with multiple streams of income:


Inventory Your Total Income- Make a list of projected income sources for the current year, using previous income listed on your 2021 tax return as a guide. Adjust the previous income as life circumstances necessitate (e.g., the start of RMDs, receipt of an inheritance, or increased or decreased earnings).


Do a Mid-Year Income Tax Mock-Up- Once you have inventoried your income, take the time in June or July to do a 2022 pro forma tax return using best estimates for tax credits, unknown income (e.g., mutual fund dividend and capital gain distributions), and tax withholding. Use the IRS Tax Withholding Estimator to check if withholding is adequate.


Arrange Tax Withholding Services- Employers withhold income taxes based on information that workers submit on Form W-4. Self-employed workers generally submit quarterly estimated tax payments or over-withhold taxes at their “day job.” In other instances (e.g., RMDs, Roth conversions, pensions, unemployment benefits), taxpayers may have to proactively request tax withholding. For withholding on Social Security benefits, taxpayers must complete Form W-4V.


Make Estimated Tax Payments- Quarterly estimated payments are often used for withholding on investment dividends and capital gains, freelance income as an independent contractor, and other taxable income where withholding was not requested. To mail quarterly payment vouchers with a check to the IRS, taxpayers need to download Form 1040-ES.


Fine Tune Withholding by January 15- The fourth- and final- estimated tax payment for a tax year is due by January 15 of the following year. By early January, most data that affects taxes is a “done deal” including tax withholding, freelance income, and mutual fund distributions. Update your mid-year tax mock-up and adjust the Q4 estimated tax accordingly.


Consider Safe Harbor Rule #1- Especially if you expect your total income to increase this year from one or more sources, withhold/estimate at least 100% (i.e., the same amount) of tax owed the previous year (110% with adjusted gross income or AGI over $150,000) by the Q4 estimated payment. This way, the IRS will not assess an underpayment penalty.


Consider Safe Harbor Rule #2- If you expect your total income to decrease from a “high water mark” a year earlier, the safe harbor rule, above, would result in over-withholding. A second safe harbor is to pay at least 90% of tax liability for the current year. There is also a third safe harbor for taxpayers who owe less than $1,000 after subtracting withholding.


Don’t Forget Self-Employment Tax- Self-employed taxpayers (including freelancers), not only have to withhold enough tax on their taxable income, but they also need to add self-employment tax to their tax bill as an “other tax” using the 1040-SE tax form and Schedule 2. The higher the net income of a taxpayer’s business, the higher the tax bite, which needs to be anticipated with withholding somewhere or quarterly estimated tax payments.


Consider “Bunching” and Withhold Accordingly- With another half-year to go, there is still plenty of time to develop a proactive strategy to exceed the standard deduction. Typically, this is done by combining one or more of the following: large qualified, unreimbursed medical expenses, state and local taxes up to the $10,000 SALT cap, mortgage interest, and sizable charitable donations. If you plan to “bunch,” check your withholding with the IRS calculator noted above.


Expect the Unexpected-  If you have invested large sums of money (at any age) or have watched investments grow over time, taxable capital gains (e.g., from mutual funds) will grow as well. Be sure to include reasonable estimates of this source of taxable income in calculations for tax withholding.


For additional information, review the IRS publication Tax Withholding for Individuals.

This post provides general personal finance or consumer decision-making information and does not address all the variables that apply to an individual’s unique situation. It does not endorse specific products or services and should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.


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