Should everyone who receives dividend income fill out a W-4 form reporting it to their employer?

Question

My friend mentioned to me that he got dinged by the IRS for underpayment of estimated tax. Apparently the reason that his employer didn't withhold enough tax from his paycheck is that he received income from dividends, which his employer didn't know about. So his taxable income was higher than his wages, but his employer only withheld estimated taxes based on his wages. Apparently he could have avoided this penalty if he'd told his employer about his dividend income by filling out a W-4 form.

I found a TurboTax web site that lists common reasons to fill out a W-4, but it doesn't list dividend income as one of them. This seems weird to me, because lots of people receive dividends, so it seems like my friend's situation would be very common. This got me wondering if my friend was correct.

Is my friend correct that anyone who receives dividend income should report it to their employer through a W-4 form, in order to make sure that the employer withholds enough tax? Do most people do this? Should I do it?

Answer 1

You certainly can use the W-4 to have more money withheld. This would be appropriate if you had regular income that was beyond that of your employment - for example, if you have $250k invested in a dividend paying mutual fund that generates a fairly consistent amount of income each year. The W-4 isn't exactly intended for this purpose, but there's no reason not to use it this way if the income is regular given how easy it is to do - set it and forget it.

However, if this is not the case - if you have unpredictable or one-time income, the W-4 is not the most efficient way to do this. In those cases, you need to do one of two things.

1. Make sure you're withholding at least up to the safe harbor, which is for most people 100% of their previous year's tax owed or 90% of this year's tax. (If you are a higher income taxpayer, read Publication 505 as the amounts required may be higher). Pay estimated taxes using https://irs.gov/Payments to get up to that amount if needed.
2. Make explicit estimated payments for the unpredictable/one time income. For example, if you receive a dividend of $20,000, and you believe it to be a qualified dividend, you could make an estimated payment of 20% ($4000) or less depending on your income (qualified dividends can be 0%, 15%, or 20% depending on your income).

It's not hard to make an estimated tax payment, as long as you remember to keep track of them at tax time. (I put a reminder in google calendar of each payment that is set to remind me Jan 31, and if I don't do my taxes right then, I move the reminder to the next few weeks, so I don't forget!)

You should make any estimated payments in the same quarter the income comes in, if possible - so if you get a $20k dividend in July, pay that $4k by September. Publication 505 has the dates the payments should be in by.

The reason not to use the W-4 for these unpredictable or one-time payments is that the next year you'll over-withhold unless you correct it again, and it's a pain to keep correcting like this. It's quite easy to make the one time payment, rather.

And again, remember the safe harbor - if you're talking a few thousand at most in dividend income, odds are you're within the safe harbor anyway. 90% of taxes due leaves you a lot of wiggle room (and no penalty under $1000, either).

Answer 2

I have found that the easiest way to make sure I reach the safe harbor amount is by adjusting my W-4 by specifying additional money be withheld with each paycheck.

Each December I get dividends in my taxable account, it isn't a predictable amount. The way I plan is to look at my paychecks each summer and see if I will have 110% of the previous years tax withheld. If I will, then no adjustment is necessary. If I am going to fall short, I adjust the W-4.

Yes I could wait until late in the year, and then make a quarterly payment in January, but I have found for me the W-4 adjustment is easy to make. Back in the days of paper W-4 forms that had to be mailed to a corporate office in another state, making W-4 changes was hard. But with my company the W-4 change is made online in the payroll system, and the changes takes place with the next paycheck. They even have a tool to see how your previous check would have changed.

You don't have to tell your boss why you are making the change in the W-4. Many married couples have to have additional money withheld to address the multiple jobs issue. I have never had anybody with the company even ask about the reason.

Is my friend correct that anyone who receives dividend income should report it to their employer through a W-4 form, in order to make sure that the employer withholds enough tax? Do most people do this? Should I do it?

Not everybody has to do it. If you are always getting a refund, then a little unexpected dividend or interest income won't make a difference. But if you sometimes get a refund, and sometimes have to pay, then you might need to make an adjustment to avoid having to pay a penalty some years.