Taxes 
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How Tax Withholding Works

TaxesIn the United States, you pay taxes on your income as you earn it. If you earn $10, you’re expected to kick the taxes to Uncle Sam every quarter in the form of quarterly estimated payments. If you earn $10 from your employer, the company has the pleasure of withholding those taxes and forwarding them to the Treasury on a regular basis. If you’re short by too much by the time tax day comes along, you’ll be hit with penalties and interest. If you’re short by just a little, then you’ll be OK.

Some personal finances experts will recommend that you adjust your withholding to minimize the amount of unnecessary withholding each month. In general, I’m in favor of that because it’s always better to keep the cash in a savings account. There are, however, risks involved in adjusting your withholding too aggressively.

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 Career 
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Decode and Understand Your Paycheck

Pay StubI remember when I received my first real pay stub, it was a mixture of happiness and absolute horror. It was my first summer internship after my freshman year of college. I was earning something like $12 and I was pumped that in my first week I’d earn $480. Then I saw my paycheck.

At first glance, your paycheck is a lot of numbers in tables. If you spend a few minutes, you can generally decode and understand what’s going on. However, sometimes it takes a little extra work because your company will use acronyms you aren’t 100% familiar with. When I looked at my first paycheck, I was able to decode it pretty easily… the Feds got their piece, NY state got their piece, and then this weirdo named FICA took a little slice. What? Who the heck is FICA?

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 Angel's Advocate 
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Adjust Your W-4 Withholdings

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This is a Angel's Advocate post.

Over two years ago, one of the first Devil’s Advocate posts I wrote was that you shouldn’t adjust with your payroll deductions. Back then, as it is now, conventional personal finance advice told you to adjust your withholding so that you don’t have too much tax withheld from your paycheck.

How do you adjust your withholdings? You adjust your withholding by submitting a W-4 to your company’s HR or payroll department with an updated number of exemptions. To determine how many exemptions you should put down, I would use the IRS Withholding Calculator because recent laws have made numerous “rules of thumb” obsolete.

Now that you know how, let’s talk about why!

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 Taxes 
17
comments

Adjusting Withholding via W4 Exemptions

One of my friends recently asked the following question about adjusting the withholding on his paycheck in order to minimize overpaying his income tax:

We recently just bought a house. We’ve never itemized my taxes before because we didn’t have enough to come close to the standard deduction. Now, however, clearly we will. We’ll have approximately $30k in write-off’s between the property tax and mortgage interest. The difference between this and the standard deduction (~$10k) is ~$20k. Using the 25% tax bracket, this means we’ll get back $5k in taxes (compared to last year). How much should I adjust my w4 exemptions so that we can get this money in our pay checks instead of a big check from the fed’s at the end of the year?

The gist of the scenario is that the difference between this year and last year is that this year he will be able to include $30,000 in itemized deductions rather than take the $10,000 from the standard deduction. How should he adjust his Form W-4 exemptions so that he doesn’t unnecessarily overpay his taxes through withholding?

The simple, for me, answer is to turn to the IRS’s 2008 Withholding Calculator because that’s the official answer (but that would be too easy!). The “rule of thumb” is that each of the exemptions on your W-4 represents a dependent deduction and each dependent deduction is worth approximately $3,400. The purpose of the W-4 was so that you could indicate how many dependent children you had and so you can repurpose this to cover all the other deductions you have on a basis of ~$3,400 per exemption. Based on the rule of thumb, the answer appears to be 9 exemptions.

Now comes the question of whether the couple both puts 9 or if one person puts 9 and the other puts 1. Since you’re adjusting your total tax liability between two people, I believe the answer is that one person puts 9 and the other puts in 1 but I’m not 100% sure. If both were to claim 9 exemptions (total of 18!), you would double counting and thus underpaying by 9 exemption’s worth. I’m not a tax expert but a few readers are, so hopefully someone can chime in on whether this is correct.

Ultimately, to be 100% sure, I’d check the IRS 2008 Withholding Calculator and then speak to a professional tax accountant.


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