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How to Adjust Your Tax Withholding

Every year, millions of American taxpayers get a tax rebate in the Spring. For some, it’s a planning tool – you can’t spend money if you don’t have it in your bank account. For others, it’s just something that has always happened. It isn’t a benefit, it isn’t a drawback, you’ve just always gotten a rebate in the Spring and it’s been a night surprise.

What if it didn’t have to be that way? What if you could do something to avoid giving the government a tax free loan each year for no reason? Fortunately there is and it involves adjusting your tax withholding on your paycheck.

This post is part of the Bargaineering Annual Financial Review [3] week series where we take a closer look at the four major facets of personal finance and see if we can do better. This post is part of day four – beating back the tax man.

Income tax is paid “as you go.” Every paycheck you receive will have a little, or a lot depending on your perspective, taken away and paid to the government in the form of federal income taxes. As you earn the income, it is taxed immediately. Your employer determines how much tax to withhold based on your Form W-4 [4].

This works well when you’re single and claim the standard deduction. If you’re married, have two incomes, claim itemized deductions, or are in any one of a million non-standard deduction scenarios, the W-4 works but it doesn’t work that well. That’s why so many people get tax rebates, their employers are withholding too much tax.

How to Adjust Tax Withholding

The easiest way is to use the IRS’s Withholding Calculator [5] to help you decide what to claim. With the various credits introduced in the recent stimulus bill, the American Recovery and Reinvestment Act of 2009, I wouldn’t trust any other calculator to give me accurate information. The calculator will tell you how to fill your W-4 once you enter your information.

Safe Harbor Protection Amounts

For the more advanced withholding adjusters, you can adjust it so that you owe a little tax at the end of the year. The government doesn’t like it when you underpay your taxes because then they are giving you an interest free loan. Fortunately, as long as the taxes you do pay exceed last year’s tax liability (110% if your AGI os ver $150,000) or is within 90% of your actual tax liability, you will not face penalties. You will want to check with your state’s rules as well because they may differ from federal Safe Harbor guidelines.

This exact topic was the subject of a recent Angel’s Advocate and Devil’s Advocate post. In the Angel’s Advocate post advocating adjusting your W-4 withholding [6], I explain a few reasons why doing this is a good idea. In an older but still poignant Devil’s Advocate post, I argue why adjusting your withholding might cause more problems [7] than its worth.

Whatever direction you decide to go on this, at least you’ll know what to do. Do you adjust your withholding?

(Photo: alancleaver [8])