Is it time to reevaluate your withholding?
Despite all the worrying and grousing we do about high taxes—and all the planning and conniving we do to minimize what we owe—the vast majority of us let the government dip deeper into our pockets during the year than we have to. The incontrovertible evidence? The tens of millions of tax-refund checks the U.S. Treasury mails out each spring are proof positive that employees routinely have too much withheld from their paychecks. During 2007, the IRS issued refunds to about 100 million Americans. That means three out of four returns filed for 2006 called for money back. All told, the government sent more than $220 billion to taxpayers. The average refund: over $2,200.
What's Wrong with This Picture?
Yes, we love our springtime refunds. In fact, it's clear that many of us are addicted to them. But there is a better way: Use a Form W-4 to adjust your withholding at work to more closely match what you'll owe the government. The form basically tells your employer how much of your salary NOT to tax during the year because the IRS won't get to tax it at tax time, thanks to exemptions, deductions, tax credits and other perfectly legal ways to hold down your tax tab.
How the System Works
Giving the government a crack at your paycheck before you get it is the linchpin of the federal income tax system. Although ours is widely hailed as a "voluntary" tax system, it works best when there is the least opportunity not to volunteer. Congress put us on the pay-as-you-go system in 1943. So, although we think of April 15 as tax day, taxes are actually due as income is earned, and employers have become the country's primary tax collectors by withholding taxes from our paychecks. The government also expects its share of income not covered by withholding—including income from self-employment, investments, retirement plans and alimony—in installments during the year.
The Form W-4
The amount withheld from your pay is determined by two things: how much you make and the information you provide your employer on the Form W-4, Employee's Withholding Allowance Certificate. Your employer knows how much you're being paid; the form shows whether you're married or single and how many withholding allowances you want to claim. The more allowances, the less tax withheld.
You get a W-4 when you start a new job and often never see one again. It's wise, however, to review your withholding allowances at least every couple of years. The tip-off that something is amiss happens when you get a big tax refund (over $1,000) or owe a healthy amount (more than 10% of your total tax bill) when you file. It's also important to review if there's a big change in your life, like getting married (or divorced), having children or buying a new home.
To understand the financial power of the W-4, consider the case of a married employee with a nonworking wife and two children and a $75,000 salary in 2007. If his W-4 claimed four allowances, the same number of exemptions he claims on his tax return, his employer would withhold $604 each month for the IRS. A new W-4 claiming ten allowances would knock withholding down to $349—and put an extra $255 a month in his pocket. That's an extra $3,060 a year.
It's not found money, though. The number of withholding allowances you claim has no impact on your actual tax bill for the year, only how much you shell out in installments each payday. Assuming the $3,060 in our example would otherwise have found its way into a springtime tax refund, adjusting withholding effectively lets the taxpayer claim the refund ahead of time in installments—by not overpaying in the first place.
Each allowance you claim exempts from withholding the same amount of salary that an exemption knocks off your taxable income—$3,400 in 2007 and $3,500 in 2008.
Alas, you can't just make up a number for your W-4. IRS regulations control how many you can claim. It's clear from all the refunds, however, that most taxpayers claim too few allowances rather than too many. If you're in that group, take the time to closely match withholding to your actual tax bill.
Sure, more accurate withholding would mean giving up that luscious tax refund check in the spring. Undoubtedly, there are plenty of willing victims of over-withholding, including taxpayers who see it as a convenient means of forced savings. There are plenty of better ways to save, though. And, perhaps more costly than the fact that the government doesn't pay interest, over-withholding can play games with your psyche. You've surely heard this joyous springtime comment: "Oh, I didn't owe any tax this year. I'm getting money back." Of course, the gratified taxpayer had probably paid thousands of dollars in tax, and simply recouped funds that had been overpaid. This delusion can inflict financial pain if it leads you to lower your guard when you're preparing your return. There's a good chance you'll work harder to shave the amount of extra tax due than to pump up a refund.
How to Change Your Withholding
If you use TurboTax, the program will walk you through the process.
If you're on your own, start by asking your employer for a blank Form W-4 and, while you're at it, check on how many allowances you claim now. (You can also download the form from the IRS.)
When you attack the form, start by shaking off the notion that all you need to do is count the number of bodies around the house. You probably get an allowance for each exemption you claim on your tax return, but that's just the beginning. The only taxpayers who aren't guaranteed an allowance for each exemption claimed are those whose adjusted gross income exceeds certain levels—$156,400 on single returns in 2007, for example, and $234,600 on joint returns. (The trigger points in 2008 are $159,950 and $239,950.) A worksheet in IRS Publication 919, Is My Withholding Correct?, shows how to take this into account when adding up W-4 allowances. If you don't have to worry about that—most taxpayers don't—claim an allowance for each exemption you claim and add extra ones if:
- You're single and have only one job;
- You're married, have one job and your spouse isn't employed; or,
- Your wages from a second job or your spouse's wages are $1,000 or less.
You also get an extra allowance if you have at least $1,500 of child- or dependent-care expenses and will claim a tax credit for these costs. And, you may take an additional allowance if you file as a head of household. And, because various tax credit will cut what you owe the IRS, you can also use them to whittle away at withholding with extra credits.
Estimate your Tax-Saving Write-Offs.
Next, determine if you can claim extra allowances for the itemized deductions and adjustments to income that will cut your taxable income. The W-4 comes with a worksheet for figuring that, but it might shortchange you. Basically, the worksheet asks for an estimate of your itemized deductions and adjustments to income, then has you reduce that amount by non-wage income—such as dividends and interest not covered by withholding—before determining how many allowances you should claim to reflect your tax-saving write-offs.
What the worksheet does not indicate is that you can also take anticipated losses into account. If you expect a deductible loss from a business or rental activity or investment, for example, you can adjust your withholding to account for the resulting reduction in your tax bill. Basically, every $3,400 of net 2007 loss buys an extra withholding allowance. (The amount is $3,500 in 2008.) Such losses are first used to reduce any estimated tax payments you must make, but if a loss will more than wipe out your estimated tax liability, you can use the excess to curtail withholding.
Taxpayers whose adjusted gross income exceeds a certain level—$156,400 in 2007 and $159,950 in 2008 ($78,200 and $79,975, respectively, for those who are married filing separately)—must take into account the fact that the law restricts their itemized deductions. A worksheet in Publication 919 shows how this affects withholding allowances.
Making all those estimates might sound like more trouble than it could possibly be worth, but IRS restrictions can simplify the job. Begin with your tax return for the previous year. If you can reasonably expect your write-offs to be at least as high for the current year, you can use last year's figures for the W-4. You can use higher figures only if you can point to something that justifies the increase, such as in the following examples:
- You buy a new home for which mortgage interest and property-tax payments will be higher than your previous write-offs in those categories.
- You are divorced this year and have to pay alimony, a tax-deductible expense you didn't pay in earlier years.
- You suffer a substantial loss in the stock market—so bad that you'll be in the red even after accounting for profits you expect to take before the end of the year. You may use your estimated net loss to raise the number of allowances claimed.
The rules don't permit adjusting withholding in anticipation of a tax-saving event. If you're simply worrying about a stock loss or considering making a big charitable contribution, for example, you can't use your fears or intentions to reduce withholding. If the IRS challenges the number of allowances you claim, you'll have to show that you used a reasonable method to arrive at the number.
Working Couples
If both you and your spouse have jobs, figure how many allowances you're entitled to together, then split the number however you choose. They're usually worth more—in terms of reduced withholding—when claimed by the higher-paid spouse. Unfortunately, though, under-withholding rather than over-withholding is the bane of many married couples. The W-4 takes this notorious reality into account with a second worksheet for working couples. Based on the income of each spouse, this worksheet walks you through the process of eliminating allowances the other rules say you deserve.
Although negative allowances may seem like a penalty, this is the IRS's way of trying to accurately match withholding to a couple's tax bill. It's possible that claiming zero allowances might still leave you under-withheld. Don't worry, the IRS has a solution. The W-4 worksheet will show how much extra tax to ask your boss to withhold each payday.
Filing a Revised W-4
Whether you decide you need more or less money withheld from your pay, filing a new W-4 with your employer—not the IRS—will trigger the change, usually within a month. That guarantees a quick payoff if your efforts cut withholding. Think: Instant gratification.
Email This Page
Printer Friendly Version
