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Most taxpayers would agree that paying more tax than they owe is not a good idea—yet millions of taxpayers do just that. They give the IRS an interest-free loan every year.
This happens when the money you have withheld from your paycheck—or send to the IRS quarterly for self-employment and investment income—exceeds your total tax bill for the year. Yes, you might get a refund. But you could have used that money to pay down debt, save for retirement, or invest for growth or income.
Adjusting your paycheck tax withholding to bring it in line with what you will actually owe when you file your tax return might be a quick way to increase your take-home pay. It could be as simple as seeing how much you overwithheld in 2013 and making adjustments to have less withheld this year.
If you received a significant refund in 2013 and you haven’t made any adjustments in your withholding rate so far this year, you might be handing over more money than necessary. This is not always the case, however. Be sure to take into account any extraordinary circumstances in 2013 that could have substantially lowered your tax liability. Maybe you had a large capital loss on an investment, or a major medical expense, or were affected by a natural disaster. If such was the case, you should look back at your returns for several previous years to see if you received refunds in “normal” tax years.
Something else to consider is whether there are—or you anticipate—events in the current year that will significantly change your tax situation. These could include getting married or divorced, having a child, or retiring. If so, you should consider making a withholding adjustment—either up or down—to reflect your new circumstances.
Unless you’re self-employed or have a large amount of investment income, the primary mechanism for calculating and adjusting your withholding is Form W-4. The upside of the W-4 is that it’s fairly straightforward by IRS standards. The downside is that it doesn’t address many of the complex situations that taxpayers may face. Think of it as trying to adjust the volume on your television with a control that has only a handful of settings.
The W-4’s equivalent of volume settings is called “allowances,” which are related to—but not the same as—the dependents or personal exemption amount you claim on your tax return. You get one allowance for yourself, one for your spouse, and one for each dependent you report on your tax return. You can also claim an allowance if you file your tax return as head of household, claim a tax credit for child care expenses, or plan to itemize your deductions.
The more allowances you claim, the less money your employer will withhold for taxes. The question is whether you want to take all the allowances you’re entitled to. If you’re part of a two-income household or you hold multiple jobs, you might want to consider claiming fewer allowances so you don’t underwithhold and have a big tax bill when you file your return. You can even ask your employer to withhold an additional amount on Line 6 of your W-4. The form’s worksheet for two-earner/multiple job taxpayers can help you decide what’s right for your situation.
If all of this sounds like too much effort, you can simplify the process by using the IRS withholding calculator. On the other hand, if you want to be more precise than the W-4 allows, you can estimate your 2014 taxes by using the 2013 tax form. Estimate your income and deductions for the year, then apply the 2014 tax rates. Be sure to take into account any major life events that would significantly alter your filing status or deductions. And keep in mind that high-income taxpayers—with income exceeding $200,000 as an individual or $250,000 as a married couple filing jointly—may be subject to additional Medicare taxes. If it looks as though your withholding exceeds your likely tax bill, consider adjusting your allowances upward, and vice versa.
People who make quarterly payments can take the same basic approach. After estimating your total tax for the year on investment and self-employment income, as well as IRA withdrawals and other retirement income, divide the amount by four and make each payment by the deadlines in April, June, September, and January of the following year. If you have any concerns about your situation, be sure to check with your tax advisor.
If you determine that you’re handing over too much to the IRS, you can make adjustments at any time during the year. However, if you provide a revised W-4 to your employer midyear, keep in mind that you have a limited number of pay periods for the adjustment to bring your withholding in line with your estimated tax for the year.
Because your calculation for the proper number of allowances to claim is based on the entire year, you might want to choose a lower number to make up for the first part of the year when you were withholding too much. The reverse is also true. If you determine that you have been withholding too little, you could bump up your allowances and instruct your employer to withhold an additional amount for the remainder of the year.
If you are a taxpayer who makes quarterly payments, the process of increasing or decreasing what you give to the IRS is even easier. Simply send in a larger or smaller amount based on your tax projection for the year. Keep in mind, however, that making a big payment near the end of the year to make up for shortfalls in previous quarters will not absolve you from possibly being assessed an underpayment penalty for those previous quarters. That brings us to the next step.
Although you don’t want to give the IRS more than necessary during the year, you also don’t want to lower your withholding so much that you trigger an underpayment penalty.
The general rule is that you won’t be hit with a penalty if your total withholding and estimated tax payments are at least 90% of your total tax owed for the year or at least 100% of what you owed in the previous year, assuming that it covered a full year. You also won’t be subject to a penalty if your total tax is under $1,000 or if you had no tax liability for 2013.
The rules are a little different for high-income taxpayers (as well as for farmers and fishermen). Taxpayers who earn more than $150,000 ($75,000 if your filing status is married filing separately) must pay at least 110% of what they owed in the previous year or 90% of their total tax due.
Making a midyear withholding adjustment can be a smart financial strategy for taxpayers who routinely receive a tax refund after filing their return. So long as you’re careful not to significantly underpay, resulting in a big tax bill next April and possibly a penalty, a little extra cash each pay period could enable you to pursue your financial goals more effectively.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
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