Is it Time to Re-evaluate Your Tax Withholding?

Each year, over 85 million people get tax refunds averaging more than $2,200. If you get such a refund, it does not mean the IRS got religion and decided to do you a favor. It only means that you've paid more taxes than you owe. Not only did you overpay your taxes, but you allowed the IRS to hold your money for more than a full year, often up to fourteen or sixteen months, without paying you a nickel's worth of interest.

Why do that?

Too many people fail to understand how to adjust their withholding to match their income tax liability. In my book, How to Double Your Tax Refund, I lay out the step-by-step process for doing this. Please review that material now to be sure that you don't spend the entirety of this year paying more taxes than you owe.

Changing Your Form W-4, Employee's Withholding Allowance Certificate

One of the key reasons for the widespread over-withholding we see every year is that people think of the W-4 form as a “file and forget” process. It’s not. The W-4 form must be thought of as a “living” document. It has to change to reflect all the changes in your life that are relevant to the form.

Form W-4 is the form you file with your employer when you're hired. It tells the employer the number of allowances you claim for purposes of federal income tax withholding. The more allowances you claim, the less the employer will withhold. The IRS publishes the withholding formula in its Publication 15, Circular E, Employers' Guide to Withholding.

What is an “Allowance?”

An “allowance,” for purposes of determining your withholding schedule, is defined as any tax return item that reduces your tax liability. For example, all your dependent exemptions reduce your tax liability. You are therefore entitled to one withholding allowance for every dependent exemption.

Also, itemized deductions (charitable contributions, mortgage interest, etc.) reduce your tax liability. You are entitled to claim additional allowances based upon your itemized deductions using a formula I present in the book referred to above.

Ultimately the number of total allowances you claim on Form W-4 should exceed your dependent exemptions, but by how much depends entirely upon your own circumstances.

Amending Your Form W-4

This means that the vast majority of citizens need to consider amending their Form W-4 because the vast majority of citizens are paying too much. Not only are you allowed to amend Form W-4, the law provides that a person “must amend” Form W-4 within ten days of the date of any substantial change to his or her tax circumstances.

I might add that you should amend the form within ten days of becoming aware that you're paying too much in taxes and need to adjust the form to correctly account for all the withholding allowances you're entitled to claim. Here are just some of the circumstances that require you to amend your withholding certificate:

• You get married or divorced,
• You have a baby or a child leaves your home,
• You buy or sell a home,
• You incur substantial medical expenses,
• You increase or decrease charitable giving,
• You begin or cease funding an IRA or 401(k),
• Your side business becomes profitable or begins losing money,
• You incur a substantial casualty or theft loss, or
• Your state income or real estate taxes are adjusted substantially one way or the other.

Get Your Tax Refund in Every Paycheck

By paying attention to your withholding over the course of the year, you'll get your tax refund in every paycheck, rather than having to wait until you file your tax return to get it. That way, you can save or invest the money, use it to pay down debt, or otherwise use the money to provide for needs.

For example, if you used the money to fund an IRA or 401(k), not only would you get the benefit of the growth over the course of the year, you'd get another tax deduction and that lowers your taxes even further.

Copyright 2008, Daniel J. Pilla Published by Winning Publications, Inc.