Avoid Paying More or Less Tax Than You Owe
Claim too few withholding exemptions and you'll end up lending Uncle Sam your money interest-free. That's not as bad as owing, but why give up the interest on your money and the use of that money during the year?
If you're one of those people who use over-withholding as a type of forced savings account, there are better ways to do it, such as having the money taken out of your paycheck or bank account automatically each pay period and placed in a savings account. Sure, you won't save big bucks at password savings account rates, but small amounts here and there add up quickly. If you don't believe it, try tracking every penny you spend for a month. I guarantee you'll be surprised (if not appalled) at how much a number of seemingly inconsequential amounts add up to.
Ideally you should claim the number of exemptions that will result in withholding as close to what you owe as possible. Since there are many things that can change your tax status throughout the year, it's a good idea to review your exemptions once or twice during the year to ensure that you're on track. Do this in early November to give you time to make adjustments by the end of the year, especially if it looks like you've been under-withheld. It pays to do it again after you've completed your income tax return for the previous year (March or April) and know exactly where you stand.
You should also complete a new W-4 and submit it to your employer if any of the following situations apply to you:
- You got a big refund last year
- You owed over $100 last year when you filed your tax return
- You got married or divorced
- You had a child
- You can no longer claim a dependent that you claimed last year
The W-4 worksheet looks confusing, so many people don't bother to use it, but it's not as bad as it looks. Remember that if you're married and you and your spouse both work, you need to account for the "marriage tax penalty," which results in the two of you owing more taxes than two unmarried people with the same income would pay. The marriage tax penalty if being phased out over several years, but until Congress removes this unfair piece in the tax code, the marriage tax penalty will probably continue to be the biggest cause of under-withholding.
To account for the marriage penalty, the authors of "Taxes for Dummies" recommend that you adjust your withholding allowances as follows:
Write down the salary of the lower-paid spouse and the number of allowances you show on the worksheet on Form W-4. Divide the lower-paid spouse's salary by $5,000. Reduce your allowances by this number. For example, if the lower-paid spouse makes $25,000, divide $25,000 by $5,000. The result is 5, so you'd reduce your withholding allowances by 5.
If the lower-paid spouse makes over $60,000 a year, cut one more allowance for every $10,000 between $60,000 and $110,000.
If you find the W-4 form intimidating, ignore the worksheet and instructions and just add one or two allowances to your current number if you were overwithheld, and subtract one or two allowances from your current number if you were underwithheld. Your payroll department can tell you how many allowances you're currently claiming.
Now is a great time to take care of this little housecleaning item to avoid paying interest and penalties if your taxes have been under-withheld this year.