How'd you like to put more money into your pocket now? If you're an employee, it's really easy.
When you started working, your employer asked you to complete a Form W-4, the Employee's Withholding Allowance Certificate. From your answers on the form, your employer determined how much to withhold in federal and state taxes.
I'll concede that the phrasing is arcane: The form asks how many "withholding allowances" you want to claim.
But here's the bottom line: Withholding allowances equal cash. The more allowances you claim, the less tax money is taken from your paycheck. And that means more cash comes to you each pay period.
Signing the W-4 the first time doesn't lock you into one set of allowances forever. In fact, federal law requires your employer to let you change your allowances at any time. Again, increasing your allowances increases the amount of money you take home now. Here's how:
- The family. You get an allowance for each exemption you claim on your tax return -- for yourself, your spouse and your dependents. Unfortunately, that's where most people stop, and, as a result, too much is withheld.
- Tax credits. You can get additional withholding allowances for the estimated tax credits you expect to take. If you expect to qualify for the earned income credit, the credit for child- and dependent-care expenses, the foreign tax credit, the child tax credit, education credits or adoption credits, these all permit you to claim additional allowances. Most tax software will help you determine if you qualify for credits. So will Publication 17: Your federal income tax (.pdf file), the big IRS guide to individual income taxes. Still not sure? Check with a tax adviser.
- Business expenses. You can get additional withholding allowances for employee business expenses, moving expenses and, if you qualify, the additional standard deduction for the aged or blind.
- Estimated business losses. You can get additional withholding allowances for estimated net losses from your business or profession, from capital losses, from losses on rental properties and from losses from farming expenses.
- IRA contributions. You can get additional withholding allowances for potential contributions to a deductible individual retirement account.
- Itemized deductions and alimony. You can get additional withholding allowances if you expect to itemize your deductions and/or pay alimony during the year.
Itemized deductions give you possibly the biggest opportunity to put a lot more into your take-home pay. The key is expected, not actual, deductions, contributions and losses. Additional withholding allowances can always be claimed under the expectation of making charitable contributions, incurring higher medical expenses or borrowing money and incurring an increase in interest expenses.
Why reduce your withholdings?
The advantages of reducing your withholdings can be significant. If you're single and earn $20,000 a year, claiming one additional allowance would add about $40 a month to your take-home pay.Reducing your withholdings, of course, does not reduce the tax you owe on April 15, 2010. What it does do is put more money in your pocket now, rather than later in the form of a big refund.
Psychologically, it's great to get the big refund after you file your return. But think about it: A big refund means that you've given an interest-free loan to the federal government. It, not you, has had the use of your money during the year.
The objective you should focus on: Give the Internal Revenue Service just enough money so that you avoid any penalties. That way any interest earned on those "extra" dollars belongs to you.
You can avoid any under-withholding interest or penalties for 2009 if you meet any of the following safe harbors:
- Your net tax due is less than $1,000.
- You've paid in at least 90% of your total tax due for the year.
- Your prior year's adjusted gross income wasn't more than $150,000 and you paid in at least 100% of your prior year's total tax.
- Your 2008 adjusted gross income was more than $150,000, then for 2009, you must pay in at least 110% of what your 2008 income-tax bill was. If, for example, your adjusted gross income exceeded $150,000 in 2008 and your total 2008 tax was $20,000, you can avoid any interest or penalties for 2009 if you pay in at least $22,000 -- 110% of the $20,000.
- The American Recovery and Reinvestment Act of 2009 created another safe harbor for individuals with small businesses. Starting in 2009, if your prior year's adjusted gross income was less than $500,000, and at least 50% of the gross income from that return was from a business that employed no more than 500 people, your safe harbor is now 90% of the tax for the current or preceding year.
No matter how much you may owe in April, if you meet any of these safe-harbor requirements, you escape all under-withholding interest and penalties.
In the worst-case situation, you can take the "extra" dollars and put them in a money market fund each pay period. This cash will be there April 16 if taxes are due, and at least you've earned some incremental dollars in interest.
Unlike estimated tax payments, which are always due on specified dates (April 15, July 15, Oct. 15, and Jan. 15 of the year following), payroll withholdings are expected to be paid evenly throughout the year. Some sophisticated, tax-knowledgeable individuals significantly under-withhold on their income for the first 11 months of the year, file an amended W-4 and then significantly over-withhold in the last month to make up the difference.
As long as you meet any of the safe-harbor rules above, you'll escape interest and penalties for under-withholding.
So take a look at your W-4. I'll bet you'll be glad you did.