Tips for planning for next year's tax refund...today!Mar 17, 2001 (Updated Mar 19, 2001) Write an essay on this topic.
The Bottom Line Learn about how you can change your withholding level to better manage your taxes and take home pay!
This got a bit long winded, but there is a lot of information associated with how taxes are deducted from your paycheck, and I think if you read through the entire essay, you'll learn something to help you manage the taxation process.
If you look at my profile briefing over there to the left, you'll see that I'm into software engineering. I'm also one of those Uber-Geeks who's also an accountant. About 15 years ago, I wrote a simple payroll program so I could get paid quicker. That's morphed into the best selling MacOS payroll program of all time and was selected by Intuit as their payroll solution for QuickBooks for Mac.
So, in some ways, I've lived payroll for quite some time. Hopefully, some of my knowledge can help you manage one of those monumental tasks, taxes.
First of all, a disclaimer:
This is general advice, which, depending on the laws or your state or municipality, may not apply to you. Always consult with a local human resources person, payroll clerk or accountant to make sure that you're doing what you intended to do.
I'm not going to get into whether over withholding and getting a big refund or under withholding and not giving the IRS an interest free loan is a good idea. That's for you to decide -- I'll just tell you how to achieve whichever of these goals you choose.
What are taxes and deductions?
If your boss pays you $1000 a month, that's your "gross pay". You will never get $1000 a month to put in your bank account, because you need to pay taxes and deductions each pay period. Taxes are things that go to the government and deductions are additional items like health insurance premiums or a pension plan.
What can I control about taxes and deductions?
You (generally) have complete control over deductions. If you don't want health insurance or get it somewhere else, you can ask that it stop being withheld. Some things (like union dues) are mandatory and cannot be discontinued. The next time you're paid, read carefully the check stub and make sure that you understand each and every thing that's being withheld.
You can change the amount of Federal (and in some states, State) Income Tax. You cannot change either of the "FICA" taxes, which are Social Security and Medicare, except by changing your gross pay (which I detail later.)
The remainder of this article will deal with how you can change your Federal Income Tax withholding.
How Federal Income Tax is Calculated
If you pick up a copy of Circular E (a federal publication which you can read online at http://www.irs.gov) you'll see pages and pages of "look up tables", where you look up how much taxes need to be taken out.
However, unless your company is very small, they don't use the look up tables, they use a fairly simple mathematical formula, which is:
Taxes = ( (Adjusted Gross) - (Claims) ) * (Tax Rate)
For the mathematically challenged, that means that we take your "adjusted gross" (more about that later) and subtract an amount that corresponds to the claims that you have made. From that result, we multiply it by the tax rate, which tells us how much income tax to deduct.
What's important about this formula is that you can change everything on the right side!
Let's look at each part separately:
This is provided on Form W4, and indicates how many "people" you support.
If you do not "itemize deductions" when you file taxes at the end of the year (which means that you file Form 1040 and Schedule A) enter the actual number of people that you support in your family. For example, if you're married with one child, enter '3'.
If you do itemize deductions, you can use the claims number to account for some of them. For example, I support two people (myself and my daughter) but claim five, because I have a big house with a big mortgage, so I have a big interest deduction. If you have a lot of interest expense, employment expenses or give a lot to charity, you might consider bumping this number up.
Increasing the number of claims will a) increase your take home pay each check, and b) reduce your tax refund at the end of the year.
Decreasing the number of claims will do the opposite -- you'll have less money on each check, but a bigger refund when you file taxes.
There are no specific requirements for determining the number of claims you want. However (and this is a BIG however) you may find significant penalties at the end of the year if you didn't withhold enough and have to pay (rule of thumb: Don't make your "taxes due" on April 15 more than $500)
This varies by two factors, marital status and annual income. The United States has a "progressive" tax scale, which means that the more you make, the higher your tax rate will be. Suggestions for altering your annual income will be found below.
As for marital status, this gets a bit tricky, because as of now (3/01) there is a potential pitfall. The "married" tax rate is lower than the "single" tax, but without careful consideration, you may find a problem.
For example, let's say that John and Jane Doe are married. John makes $18000 a year and Jane makes $60000. They both claim "married" on their W4. The problem is that John's wages are taxed as if his entire family income was $18000 per year. From a payroll clerk's point of view, John's pretty poor and probably won't have any Federal income tax withheld.
The problem comes at the end of the year, when John and Jane combine their income to pay taxes. All of the sudden, they have $18000 of income they didn't pay taxes on, will have a significant tax bill, and likely have to pay a large penalty.
John should have claimed "single" as his marital status, zero claims, and had "extra withholding" added to his check to make up the difference. If you find yourself in this situation, talk to your payroll or HR clerk about how you should fill out your W4 form.
There are four "marital status" options, each with their own withholding rates -- single, married, head of household (for single people with dependents) and "married filing separately." Almost no one should use the last option -- it has a significantly higher tax rate.
The final part of the equation that you can change is your income, although you need the company's help to do it. Of course, you can always just ask for a pay cut, but there's a better way to do it.
The difference between "Gross" and "Adjusted Gross" is that adjusted gross takes into account deductions (remember those?) that are "sheltered" against federal taxes. There are numerous types of these, but the most important ones that you can control are called "insurance," "pension" and "flexible spending accounts".
What does this mean? Let's say that I make $1000 a check, and pay sheltered insurance premiums of $100, along with $100 to a 401k. Instead of calculating Federal, State and FICA taxes on $1000, it is calculated on $800. So the $100 is probably closer to an $85 actual reduction in pay.
Most health insurance premiums (health, dental, etc) can be sheltered if your company files the required 5500 Form and adheres to the federal regulations. This is the easiest to implement for a company, because they're not adding additional services. Ask whether your insurance premiums are being sheltered and if they aren't, suggest that they look into it. The company saves money as well, because FICA match and unemployment insurance (both of which the company pays) are also sheltered.
Qualified retirement plans (eg: 401k, IRA) can be sheltered against taxation. This requires some expense of the part of the company, so small companies may not offer it. In that case, open an IRA on your own and have money automatically deposited. You'll get a tax deduction at the end of the year, rather than on each check, but it's better than nothing.
Flexible Spending Account
Also known as Section 125 Cafeteria Plans, these allow you to set aside a part of each paycheck to pay for medical and/or dependent care (eg: daycare!) You have to spend the entire amount over the course of the plan year or you will lose the excess, but in the case of daycare, that should be easy to budget. There is some amount of administration costs, and potentially significant liability on the part of the company, so many small companies will not offer this.
A while back, I wrote a "tax calculator" for the web, which you can access at:
Someone else maintains it now, but it's still a great tool for playing around with the number of claims and marital status to see how your taxes and take home pay change.
There are other online calculators available, including one at:
which includes the ability to calculate state taxes.
With careful consideration, you can start to manage next year's tax return today. Determine what you want (a big refund, no refund, tax savings, etc) and work with your payroll department to accomplish that goal. The IRS has made things flexible enough that a well informed person has significant control over how much taxes they pay on each check.
|Read all comments (5)|Write your own comment|