Withholding versus FICA, and why a refund is not a win
Two very different things come out of a paycheck and they are usually printed next to each other. One is an estimate that reconciles in April. The other is a charge that never reconciles.
Withholding is an estimate
Federal and state income tax withholding is a prepayment against your annual bill. The amount is set by your W-4, your filing status, dependants and any extra amount you chose. Withhold too much and you get a refund. Withhold too little and you owe a balance, plus a possible underpayment penalty if you missed a safe harbour, generally paying in 90 per cent of this year's bill or 100 per cent of last year's, whichever is lower.
FICA is a charge
Social Security and Medicare are calculated on the wage to the cent and are already correct at the end of the year, apart from errors. They do not generate a refund and are not affected by dependants or filing status. If your refund is larger than a hundred dollars or so, it is income tax withholding, not FICA.
Why a refund is a bad savings plan
A refund is money the government held interest-free. On a $3,600 refund you gave up $300 a month for a year and were paid back the nominal sum in April. Nothing about it improves your tax position; the tax was the same either way. The only argument for a large refund is discipline, that you would otherwise spend the money, and even that is served better by a direct deposit to savings on payday.
Getting it right
- Run the IRS withholding estimator mid-year with a recent stub and last year's return.
- File a new W-4 with the calculated extra or reduced amount. There is no limit on how often you may file one.
- Re-check after any change: a second job, a spouse starting work, a new dependant, a bonus, or an exercise of equity.
- Check in the fourth quarter that you are inside a safe harbour, so a balance does not carry a penalty.
A caution on bonuses
Supplemental wages such as bonuses are often withheld at a flat 22 per cent, which for higher earners under-withholds. The tax is set by the annual total, so a bonus year is worth re-running the estimate rather than trusting the flat rate.