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16. Don't Lend Uncle Sam Money

By Smart Money
Published | Updated

If you had a big refund this year -- or a staggering tax bill -- now's the time to correct things.

Do you have a juicy tax refund coming your way this year? Or were you once again blown away by how much you owe? It could be a sign that the amount your employer is withholding from your paycheck is out of whack. Ideally, you should owe Uncle Sam a small amount each year come tax time. If you're getting a large refund, you've given the Internal Revenue Service an interest-free loan of your money for the previous year -- and we're sure you could have come up with a better use for that money than that. On the other hand, if you owe more than 10% of your total tax bill, you could owe an interest-charge penalty for failing to cough up enough in advance of filing your return. And clearly, that's not an ideal situation either.

Here's what you need to do to make sure you don't get surprised again this time next year:

My Bill Is Too Big!
If you work for an employer (as opposed to being self-employed), correcting your withholding amount should be easy. Start by examining your paycheck to see how many exemptions you've claimed. (If it's not listed on your paycheck, someone in human resources should be able to help you.) If you claimed too many exemptions, your withholding won't be enough to cover this year's tax bill. (That is, assuming your tax situation is similar to last year's.) So you may want to refile your W-4 with your employer, with fewer exemptions. This would translate into more withholding from each paycheck. You can get a new Form W-4 from your employer or print one out from the IRS Web site.

Keep in mind, if you also have income from self-employment or investing, that could be the reason for your tax underpayment. If so, your fix is to start making estimated tax payments for this year or increase the estimated payments you already intended to make. For the 2005 tax year, estimated payments are due on April 15, June 15 and Sept. 15 of 2005, and Jan. 16 of 2006. You must file Form 1040-ES with each payment. Once again, you can download the form at the IRS Web site. For the full story on estimated payments, see our story.

My Refund Was Awesome!
While tax underpayments can be a nasty surprise, you should be almost as distressed to discover you'll be getting a massive refund. What should you do to avoid giving the IRS another interest-free loan this year? Do the exact opposite of the advice given to folks who are in the underpayment scenario. In other words, you may need to increase the number of exemptions claimed on your Form W-4 or reduce your estimated tax payments. Or both. But don't get carried away and create a big underpayment. Generally, your payments for the 2005 tax year (via withholding and/or estimated payments) should be enough to cover whichever of the following is the lower figure:

  1. 90% of your ultimate 2005 tax bill, or
  2. 100% of your 2004 tax bill if your 2004 adjusted gross income, or AGI, was $150,000 or less; 110% if your AGI was over $150,000.