Changing Your Tax Withholdings

Matching Your Taxes Now and the End of the Year

Several years ago, I was volunteering at an event to provide financial planning services to those who can't normally afford it.  I had a nice lady sit next to me who had fallen behind on her mortgage payments due to the economy.  She was going to be able to qualify for a mortgage modification program but she just couldn't quite come up with the extra monthly payments to figure out how to make it work.  She had brought in her paychecks (working two jobs), last tax return and a monthly expenses sheet that she had completed.  Two things jumped out at me: (1) she was still giving 10% of her income to her church and (2) she was withholding an enormous amount from her paychecks and receiving large refunds at the end of the year.  

I focused in on the charity first and reminded her that charity can start at home too.  She shrugged that conversation off pretty quickly and it was clear that I wasn’t going to win that discussion so I went straight to plan B.  We looked at her tax withholdings and her tax refund from last year and did some quick math.  If she would simply change her withholding to pay only what she needed to pay (i.e., no refund at the end of the year) she would have enough to pay the increased monthly payment plus a little additional to start contributing to her 401(k) again.  Voila!  Income shifting meant that this sweet lady who was so proud to own her house was going to be able to keep it. 

I recognize that not everyone faces the same choice - stop over withholding or lose your house.  However, it is similar in nature.  Over time, your ability to earn money on your money by not overpaying the IRS compounds and can have quite positive a wealth effect over paying too much and receiving a refund at the end of the year.  

Changing Your Income Tax Withholdings

When we start working for a company we usually spend the first day completing paperwork.  Lots of paperwork.  One of the pieces of paper hidden in that stack that we complete is the W-4 (http://www.irs.gov/pub/irs-pdf/fw4.pdf).  It is a vague looking IRS form that determines how much will be withheld from your paychecks for federal and state income taxes going forward - until you change it.  Most people likely spend a few minutes looking through it, guess at how to complete it, and then move on to the next sheet of paper.  There are two over-riding pieces of information that determine how much the Federal government and your state, if they have an income tax, will deduct from your paycheck.  The first is whether you are single or married and the second is how many allowances you have.  

What is an allowance?

Taxes are a complex beast so I won't get too deep in the weeds here.  An allowance is the IRS way of saying how much income do you want to exclude from being taxed.  On the Federal level each allowance is worth $3,900 in 2013.  This means that for each allowance that you claim, the withholding table excludes $3,900 of your income.  So if you income is $100,000 in 2013 and you claim one allowance, the withholdings table tells your company to exclude $3,800 of your income and then tax the rest according to the withholdings schedule.  In this case, a full $96,100 would be taxed even though it is likely that your taxable income for the year would be dramatically less than $96,100.  

One way to change this would be to look at your total number of deductions on your previous year’s tax return and divide that number by $3,900.  For example, if your total personal exemptions and itemized deductions last year was $30,000 then you would want to select either 7 or 8 allowances.  

What is the impact of Married versus Single

The primary impact of checking married or single on the withholding worksheet is it determines the rate at which your income is taxed.  Much like the tax return at the end of the year, your withholdings are taxed using a graduated formula. If you select Single or “Married, but withhold at the higher single rate” you are opting to have more taxes withheld at the higher tax rates.  This can be a good choice if you are high up in the income world and are impacted by certain phaseouts and/or have additional income outside of your salary. 

Summary

It is a lot of information but certainly worth reviewing your allowances and trying to figure out the best way to minimize the amount of taxes that you pay with each paycheck.  Of course, technology has become our friend and really helps in this instance.  You can get a better understanding of how much you should be withholding by visiting the IRS withholding calculator (http://www.irs.gov/Individuals/IRS-Withholding-Calculator)  

Good luck increasing your net pay so you can afford whatever it is that you can't right now - hopefully it is something worthy of your EARNED income.