Why is rule-2 risky ?
Often people's earnings increase, say about 5%, each year, due to raises, cost of living increases, and investment growth. So tax-owed goes up by a similar percentage. For example, suppose last year you owed and paid $10,000 in total taxes. This year, assuming a 5% increase, you might owe $10,500, and 80% of this is only $8,400. So theoretically by rule-2, you could withhold as little as 8,400/52 = $162/week. You can then wait until April 15 next year to pay the remaining tax amount.
However, it is often very difficult to predict how much taxes you will owe by the end of this year, for the following reasons:
It should also be noted that rule-1 applies to everyone, while rule-2 does not apply to some people in special situations. For example, if you paid a penalty for under-withholding last year, or you filed late, or did not pay all your taxes owed last year, -- then the 80% rule (Rule-2 above) does not apply to you.
Considering the example above, rule-1 would have you deduct $10,000/52= $193/week. It makes no sense to withhold more than that. It is perfectly safe, no risk, applies to everyone, and is still somewhat minimal.
Exceptions include cases where you know for certain that your income will drop later in the year, such as for example if you are planning unpaid leave, are retiring or quiting all work, etc..
Many other formulas for estimating withholding deductions have been proposed, but the ones implemented here seem reasonable, appear to be universal, and are easy to apply. They certainly apply to USA Federal Taxes, and as far was we know, apply to all (or most all) States. Please let us know of any exceptions.
Basically, if you are getting big tax refunds every year, then you are probably deducting too much. Ideally you always want to owe a small amount of tax by year-end. You want to wait as long as you can before paying. This lets you use the money longer. And therefore, since you should owe money, you should never want to file early, but pay as late as possible by filing closer to April 15.
As mentioned above, it is a good idea to check and adjust your withholding deductions about mid-way through the year, while there is still time to correct. The calculations are fairly simple, but since we all have to do them every year, we have combined them into a convenient program. Just enter last year's tax amount (or say 85% of your predicted taxes for this year, if you feel lucky about taking risks), and enter the total taxes paid on your (and your spouses) most recent paychecks, with the paycheck's date. The program than tells you how much you should adjust your weekly payroll deduction for the remainder of the year.
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