Tax Refund vs. Bigger Paycheck
What's your preference: a big refund check when you file your taxes, or more take-home pay each payday? The correct amount of federal and state tax withholding can help you fine-tune your tax planning so you get the money when and how you need it. Changing your withholding is simple and gives you more control over your finances.
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Reluctant Savers
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If you find it difficult to save each month, choosing to get a larger refund may help you. For many of us, it's tempting to spend the extra money in each paycheck rather than putting it away for retirement, the kids' education or saving for a future large purchase like a home or car. If you have enough willpower to bank the whole refund you get from having more withheld each paycheck, then this is the way for you to go. For example, if you adjust your withholding to take an additional $100 per month over what you actually owe, you'll get a refund of about $1,200 when you file your income taxes. Even if you spend part of it on something special, you'll still have some extra to put in the savings account.
Struggling Month to Month
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If it's a challenge to cover each month's bills, you are better off having only the required amount of tax withheld each pay period. In the long run, putting living expenses on credit cards will cost you plenty in interest while you're waiting for that annual tax refund. Avoid giving the federal government or state a free loan when you need the money during the year. They don't pay interest while they've got your money tied up. For example, if you got a $2,000 refund, you could adjust your withholding amounts and get about $166 more in take-home pay each month. Or split the difference and get about $90 more a month while still getting nearly $1000 back when you file your tax return.
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How Much to Withhold
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Remember those W-4 forms you get when you start a new job? You probably filled one out without thinking how it affects each paycheck. It's time to re-evaluate your withholding amounts. You may change the withholding whenever you like by asking your payroll or human resources department for a new W-4 (or state equivalent) form.
There's a useful worksheet at the bottom of the form that will help you fill it out correctly. Answer all the questions about marital status, number of dependents, how many jobs you have and what you earn in order to correctly calculate withholding. Pay particular attention to the Two Earners/Multiple Jobs Worksheet if you are married and you and your spouse work, or either of you collects a taxable pension.
If you want to increase your withholding to meet a particular annual savings goal in addition to the required amount, divide the total amount by the number of pay periods in the year and put the amount on line 6 of Form W-4.
When to Adjust your W-4 Withhholding
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Even if you're satisfied with the balance between the size of your paycheck and your refund, don't forget to adjust your withholding when you have life changes that will affect the amount of tax you owe. Marriage, divorce, having a child or if a child is no longer a dependent will all affect your filing status and your allowable exemptions. Go over the W-4 worksheet again and adjust the number of exemptions you claim for withholding to make sure you won't get any unpleasant surprises at tax time.
For example, if you have a child who moves out of the house you'll lose an exemption on your tax return, which means you'll owe another $3,650 in taxes for the year. By reducing the number of exemptions on your Form W-4, you'll avoid under-withholding and possibly owing tax in April.
Avoid Underwithholding Penalties
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While it's important to balance monthly take-home pay with the size of your tax refund, it's never a good idea to deliberately under-withhold taxes from your paycheck. The IRS has increased penalties for taxpayers who do so. You may face a fine of up to $1,000 for knowingly submitting false information on a W-4 to avoid withholding. If you have large deductions on your Form 1040 or unusual circumstances during the year, you won't be penalized for under-withholding from each paycheck. However, if you find you owe much more than expected at tax time, re-examine the amount of withholding and make adjustments to avoid a penalty in future tax years.
State Tax Withholding
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If you live in a state with an income tax, your employer will have to withhold state taxes from each paycheck. You should be sure the state withholding is accurate just as you do for your federal withholding. Each state has a form equivalent to the federal Form W-4 and you can get a copy from your employer or on your state's income tax agency website.
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References
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