Income tax withholding tips
Tax filing season is all but over. Taxpayers who have already filed likely received refunds. Just as likely, those who have not yet filed do not expect to receive money back and are envious of those who did. Reports are that the average refund this year is around $3,000.
Every year financial experts point out that getting a big refund means the government has enjoyed an interest-free loan of your money. But, given the low, low interest rates that savings accounts are earning, many consumers figure they really are not missing out on much money at all and believe the "forced" savings is well worth it.
There is another aspect to the big refund question that taxpayers should consider when determining withholding amounts. Many taxpayers carry credit card debt and often at much higher interest rates than just a few years ago. Taxpayers who carry a credit balance may want to reduce their withholding amounts and their big refunds and put that additional income toward debt reduction.
Consider the case of a taxpayer with a $4,000 credit card balance and a 21 percent interest rate who regularly uses the card each month but pays off the new charges and accrued interest every 30 days. This taxpayer plans to put the $3,000 refund in the spring all toward debt reduction.
However, by reducing the withholding amount and spreading the big refund over 12 monthly debt payments of $250 each, the taxpayer would save $225 in interest charges.
Generally speaking, if you receive a large refund, you may want to consider having less withheld so you have more cash on hand to reduce expenses such as the interest costs in this example. If you owe a significant amount, it may be best to have more withheld so you can avoid a crisis next April.
Taxpayers can change the withholding amount on their paychecks by submitting a W-4 Form to their employer. Increasing the number of allowances on the form will decrease the refund, but you'll have a bigger paycheck each month. Reducing the number of allowances increases the amount withheld, and you'll owe less at tax time. Form W-4 includes a worksheet that can help pinpoint the appropriate number of allowances to submit.
There are also situations where not adjusting withholding rates can cause problems. Consider the following.
Changes in filing status or number of dependents can result in unexpected tax bills when taxpayers fail to adjust withholdings when family circumstances change.
Consider the case of Mary, a single mom who had been filing as "head of household with one dependent" and had taxes withheld accordingly. Last year, her daughter moved out on her own; however, Mary did not adjust her withholding. At tax time, she was taxed at the higher single rate (compared to the head of household rate) and could no longer use her daughter's exemption. The result was $1,500 tax due for 2011 instead of the $400 refund she received last year.
Adding to her dismay was the fact that she is still in the same predicament for 2012. The Internal Revenue Service provides a resource for this kind of need. Its website, www.irs.gov features a link to a withholding calculator.
Using it requires entering information from the most recent paystubs and projections for expected income, credits and adjustments. Mary used the site and received some very specific recommendations. Her current withholding rate was projected at $1,050.
Her tax due was projected at $2,450, meaning a projected bill of $1,400 next April. The recommendation was to change her W-4 to "single with one allowance."
If this change is made in time for the next pay period, the projection is for a $50 refund instead of the $1,400 shortfall.
The calculator did not suggest what the new withholding amount should be, but quick math indicated that Mary would need to have $105 withheld each paycheck for the rest of the year instead of the $42 that had previously been withheld. Though a tough adjustment to make, it may be easier than finding an extra $1,500 to pay in taxes come April.
Another circumstance to watch for is a big change in other credits taxpayers are used to receiving. Many filers benefit from education credits that significantly reduce their tax obligation and frequently contribute to large refunds. When schooling is over, those refunds can turn into amounts owed if adjustments are not made.