As another tax season came to a close, it hit me how there’s a problematic culture in America regarding tax refunds. As an Enrolled Agent of almost a decade, I find it worrisome that people get into competitions among friends and co-workers over who got the biggest refund: it not only brings out the numerous shady services that claim to offer bigger refunds than their competitors (a reputable tax professional will only promise you that they’ll do whatever they legally can to minimize your tax liability, not claim they can get you a bigger refund than the person down the street) but it’s likely there’s money right in your paycheck that is better off in your pocket than sitting in the Treasury, interest-free.
The first thing to know about minimizing your tax liability is that there’s a strong chance your income tax withholding is unnecessarily high. Let’s examine the withholding process, and how the withholding amount is determined.
Withholding Tables & the Misconceptions About Allowances
Every year, the Treasury and state taxation departments draw up withholding tables based on filing statuses using numbers called allowances.
Your paycheck’s skeleton! Internal Revenue Service, Publication 15
These tables are indexed according to filing statuses (more on that later) and how often you get paid. Allowances are then chosen by you when you fill out on an IRS Form W-4, Employee’s Withholding Certificate, and the state equivalent (such as New York’s IT-2104.) These forms must be filled out whenever you start a new job or would like to change your withholding at your current job.
Most of the time, the worksheets above and below this piece of the form are unnecessary. The principle is simpler than it looks.
Internal Revenue Service, Form W-4
Allowances are numbers tied to how much tax gets taken out of your paycheck. Allowances tend to be based on circumstances that lead to lower taxes such as having dependents, owning your home, or being a student, and the more allowances you claim, the less gets taken out in taxes. For instance, most unmarried people earning less than $40,000/year with relatively simple financial situations tend to withhold at Single – 0 or Single – 1 which leads to a larger withholding than necessary.
Check last year’s tax return and compare the amount on the line that says “Tax” (line 44 on Form 1040, line 28 on Form 1040A, and line 10 on Form 1040EZ) to how much you have withheld. If there is a huge disparity and you get most of the money back you don’t need as much taken out.
I’ve frequently heard on the job, “My cousin’s barber’s psychic told me I should just enter 0 on that form, that way you get a bigger refund!” Yes, but then you also get less money immediately available to use. Why have that money sit in the Treasury for almost a year, not earning you any interest or making you a bit more comfortable when bills arrive?
There is also a common misconception that you can’t claim more than one allowance on a W-4 if you don’t have any of the above situations, or that the number of allowances is based on your number of dependents, and both assumptions are untrue. However, it’s unlikely you will attract any taxing authority’s attention unless you enter an egregious number (which would be virtually any number greater than 10 for most incomes) of allowances on your withholding certificates.
Under-withholding is possible and does carry a penalty if the IRS and/or states determine you didn’t pay in enough during the year (which for most people means owing over $1,000 at tax time), but chances are that if your wages or salary are your only or primary source of income, and you typically get most of your withholdings back, you don’t need to have as much withheld to begin with.
Make Sure Your Filing Status is Correct!
Are you withholding taxes using the correct filing status, as well as filing your tax return with the correct status?
The basic filing statuses are single, married filing jointly (MFJ), married filing separately (MFS), and head of household. Single and MFS will have higher taxes withheld than MFJ. Head of household means that you are not married and have at least one qualifying dependent, who is either a qualifying child or a parent you support. If you configure your withholding based on head of household status then you will have less money withheld than single and MFS. Qualifying widow(er) is a rarer filing status for surviving spouses in which you have at least one qualifying child, and you will receive many of the same tax benefits as MFJ.
However, the reason why filing status is an important distinction to make is because I’ve frequently seen heads of household withholding as single, or even filing as such, and it’s not giving them the tax relief to which they are entitled such as a larger standard deduction than single. MFS filers also tend to file as single, and, when doing so, they risk incurring a penalty and erroneously receiving benefits to which they are not entitled such as claiming the Earned Income Tax Credit which single filers can claim, but MFS cannot. Many people also continue to have their taxes withheld using the single rates after they get married (or the other way around if they get divorced) then forget to change their withholding.
Making sure you’re using the correct filing status, and therefore the right withholding table, will eliminate headaches! My years of experience in tax practice have shown that clearing up confusion over filing statuses makes both withholding calculations and tax time easier.
How Do I Know How Many Allowances Are Right For Me?
Those worksheets on the withholding certificates are like hydras: slay one head, six more annoy you while the other one just grew back. Fear not, though: paycheck calculators will burn that beast’s heads!
First, how often do you get paid? Most people get paid weekly or biweekly. There are two separate tables for those frequencies so make you got the right one. Select your state; most states have an income tax, and don’t forget local withholding either, such as if you’re a New York City or Philadelphia resident.
Next, enter your gross pay per paycheck, not your take-home pay. Your paystubs should show the amount of your gross pay prior to FICA and income tax withholding.
For example, Tina Taxpayer earns a salary of $39,000. She’s a single NYC resident and doesn’t have any other income. She gets $1,500 gross pay every two weeks. Using the 2013 tax rates, and withholding at Single – 0 across the board, here is what her calculator looks like:
© Symmetry Software, Inc.
Since she doesn’t take any special deductions or have dependents, Ms. Taxpayer’s tax liabilities are $3,908 to the IRS, $1,695 to New York State, and $972 to NYC. Under 0 allowances, $5,128.76 was withheld by the IRS, $1,728.74 by the state, and $1,087.06 by the city resulting in a federal refund of $1,221 and state refund of $149.
Under 2 allowances, $3,903.64 is withheld to the IRS, $1,599.78 to the state, and $1,009.06 to the city, resulting in two minor tax liabilities: $4 to the IRS and $58 to New York. These are liabilities too small to incur underpayment penalties, and very close to breaking even. This also frees up an extra $110.16 a month for Ms. Taxpayer, or $1,321.92 for the whole year. If your total W-2 income is less than Ms. Taxpayer’s as well, chances are you can have less withheld for similar results.
Try playing around with allowances on both the federal and state/local levels to identify an amount with which you will be comfortable. In my professional opinion, it’s best to come close to breaking even at tax filing time. Whether the results are a small refund or negligible amount owed like in the example, it’s money best off available to you throughout the year. Check out which number of allowances work best for you and your individual tax situation and cash flow, and what you’d be comfortable having withheld or paid at tax time. The amount can vary depending on what kinds of deductions and credits you qualify for and if you have other income, but I hope this information helps struggling wage earners who don’t want to wait until tax time to get some relief!
CIRCULAR 230 DISCLOSURE: Any U.S. federal tax advice contained in this writing (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.