If You've Got a Tax Refund, You're Crazy

This week Gail addresses tax refunds, and why you may want to make some adjustments to make sure you're not having too much of YOUR money withheld for taxes.

Hi, Gail-
My husband and I just received our tax refund — about $3,500. He thinks this is great because we typically use it to buy some big-ticket item for the house or for a vacation. But I keep thinking we’re losing a year’s worth of interest on that money. How do we have less money taken out of our paychecks (we both work) so this doesn’t happen again next year?

Click here to visit FOXBusiness.com's Tax Planning page.

Dear Trudi-
According to the IRS, the most recent figures indicate that well over 94 million taxpayers overpaid their income taxes last year. Typically this happens because you’re having too much taken out of your paycheck each period.

Guess what? Uncle Sam loves you!

Those extra dollars that your husband thinks of as “forced savings” are literally a free loan to the federal government. This year the average income tax refund is $2,197. That amounts to $183/month that people could be using to pay down credit card debt or fund an IRA! As you point out, Trudi, even if you simply stuck that amount in a bank account each month, you’d at least earn interest on it.

Now that tax season is over, most Americans know whether they over-paid (or under-paid) their taxes last year. So it’s a good time to re-evaluate how much you’ve instructed your employer to withhold from your paycheck and whether that amount still makes sense. “That’s the topic of conversation with clients right now,” according to Kathy Dettling, an accountant specializing in payroll processing, in Mars, Pennsylvania.

It’s a cinch to change your withholding. All you have to do is submit a new Form W-4 to your company payroll department. If you’re like a lot of people, you may not have adjusted this since you began working at your current job.

Form W-4 asks you to list how many “allowances” you are claiming. “Allowances” are a lot like “deductions” and “exemptions” — they reduce your taxable income and, thus, the amount of federal income tax you’ll owe. The more allowances you have, the smaller the amount withheld from each paycheck. Often, the number of allowances you have is different than the number of dependants you claim on your tax return.

Greg Rosica, a tax partner at Ernst & Young and contributor to the “Tax Guide” the firm publishes each year, says consider two individuals who earn the same salary, are both married, and have the same number of children. The only difference is that person “A” has a mortgage and pays property taxes while person “B” rents.

Because the mortgage interest and property taxes paid by “A” reduce her taxable income, her tax bill will smaller than “B’s”. Even though each family has the same number of individuals, “A” should claim more allowances than “B” to reflect the fact that “A” has more deductions and, thus, will owe less tax.

Your company payroll department can supply you with a new Form W-4 or you can download it from the IRS website: www.irs.gov. Although there is a worksheet attached to this form, do yourself a favor and skip it -- it’s only designed to give you a rough estimate of what your allowances should be.

A much more accurate approach is to use the withholding calculator on the IRS website. You’ll find it at www.irs.gov/individuals/article/0,,id=96196,00.html. As the instructions advise, you’ll need your latest pay stubs — yours and your husband’s — to answer the questions. It will probably take about 15 minutes to complete. When you’re finished, you can print out a new W-4 to submit to your employer. You’ll also get an explanation of how it was computed, which is worth saving.

I found other websites offering withholding calculators, but frankly, why bother? If you were ever questioned about how you arrived at your number, the IRS would have a hard time arguing with the results of its own software program.

However, if there hasn’t been a major change in your financial situation compared to last year* — (i.e. your income is about the same) you don’t have a new mortgage, there are no new members of your family, you don’t expect any major medical expenses, etc. — there’s an easier way.

Here’s how to make a mid-year correction:

Step 1: Estimate what your total federal income tax bill will be in 2006 by pulling this number off your 2005 tax return.

Step 2: Add up the total amount of income tax (not FICA) that has been deducted from your paychecks so far this year.

Step 3: Compare your annual estimate to the amount of income tax you’ve paid year-to-date. In your case, Trudi, let’s say you expect to owe a total of $20,000 in income tax this year — the same as in 2005. Through the end of May you and your husband have already paid $12,000. This means that, ideally, you only need to have $8,000 more withheld over the remaining seven months of this year.

If you increase your withholding allowances you will reduce the amount of salary that is subject to withholding tax. The question is: how many “allowances” should you add?


Step 4: Divide the remaining amount of tax you estimate you’ll owe this year by the number of pay periods remaining. Let’s say that you and your husband are paid semi-monthly, that is, every two weeks. Assuming your W-4 change is processed in time for your first paycheck in June, that leaves 14 more paychecks coming this year. $8,000/14 pay periods= $571 (rounded). This is how much you want withheld per paycheck.

Step 5: On a new Form W-4 skip Line 5 which asks you how many “allowances” you’re claiming. Instead, write “$571” on line 6. This directs your employer to withhold a specific dollar amount instead of basing your withholding on a certain number of allowances. You can have the entire amount withheld from either your paycheck or your husband’s, or you can divvy this up between the two of you.

Done. If you have an accurate handle on how much more tax you’ll owe this year, “dividing the remaining about by the remaining number of paychecks is the safest approach,” says Dettling.

Be careful! The IRS asked me to remind you that if you make a mid-year correction which decreases your withholding amount, be sure you submit a new W-4 to your employer before the start of 2007 that is based on what your withholding should be for an entire year. Otherwise, you run the risk of being penalized for having too little withheld! The best way to compute this is to use the IRS withholding calculator and input annual numbers.

Since it can take weeks for a change in your W-4 to be reflected in your paycheck, you’ll want to check with your payroll department in November to make sure you get the paperwork submitted in time for your first paycheck of ’07.

Keep in mind that withholding should be calculated based on how you file your taxes. If you’re married and file jointly, you are considered “one” taxpayer. This means you will do these calculations based on your combined earnings, adjustments, exemptions, credits, etc.

According to the IRS, if both spouses work “your withholding usually will be most accurate when all allowances are claimed on the form W-4 for the highest paying job and zero allowances are claimed on the others.” However, as mentioned above, you and your husband can divide your allowances any way you want so long as you don’t “double-dip.” In other words, if you claim two allowances because of the kids, your spouse cannot take them, too.

I know what some of you are thinking right now: “Why not ratchet up the number of allowances I’m claiming so that few, if any, taxes are withheld from my paycheck?”

Try this: It’s illegal. You can get slapped with a $500 fine and possibly jail time if you deliberately falsify your W-4 information. But that doesn’t mean you shouldn’t increase your allowances if you’ve got a legitimate reason.

In addition to the online IRS calculator, you might find the following helpful:
IRS Publication 505: “Tax Withholding and Estimated Tax
IRS Publication 919: “How Do I Adjust My Tax Withholding?”

Hope this helps!

Click here to visit FOXBusiness.com's Tax Planning page.

*Typical events that trigger a withholding adjustment:
Death of a spouse
Had a baby
Adopted a child
Took a second job
Got a raise
Adult child moved out
Bought a home
Re-financed a mortgage
High medical expenses

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.