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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Wednesday, October 6, 2010

Are Your Tax Refunds Too Large?

If you receive a large tax refund each year, you are in effect loaning money tax free to the Federal government. People with irregular income: sales people, people earning bonuses, and those with large tax deductions such as rental losses, capital losses, large itemized deductions, etc., often receive large tax refunds.

Often the large tax refunds are caused by a common misconception regarding payroll tax withholding. The number of allowances you claim on your payroll withholding form W-4 does not have to match the number of exemptions you are legally required to claim on your tax return. What you put on your W-4 is only a guide to let your payroll department know how much to withhold from your paycheck.

Consider a specific example, a married couple with two children who have been getting refunds between $7,000 to $10,000 each year. They are feeling very pinched each month. But since they have large deductions and/or credits such as a rental property at a loss and a college lifetime learning credit, they are getting large tax refunds each year. Instead of each of them claiming “Married with four allowances”, they should change their withholding to seven allowances in order to get more money paid to them each payday.

How do you determine how many allowances to claim? Prepare a tax plan to determine the estimated refund you will get if you don’t change your current withholding (Note: if you use Turbo Tax or some other tax preparation software, you can create a pro-forma tax return for the current year by estimating the same types of income, deductions, etc that you included the year before).

Take that refund number and divide it by the number of paychecks remaining in the tax year. Don’t forget that if you are paid every two weeks, you receive 26 pay periods per year instead of 24 (paychecks twice every month). Then obtain the IRS Circular E (Publication 15). Find the chart that corresponds with your filing status (single, married, etc.) and the frequency of your paychecks. Find the amount of gross income from each paycheck and match it with the corresponding row in the chart. Then, in the columns to the right of that row, find the dollar amount of withholding you want to change your withholding to. The number at the top of that column is the number of allowances you need to claim. Remember, the higher the number of allowances, the less withholding from each paycheck. If your income is higher than the charts show, follow the formula included in the Publication.

For many, the method above may be a bit complicated. Here’s an alternative method. It’s also possible to tell your payroll department to withhold a flat dollar amount from each paycheck. You’ll need to check with your payroll department first, but generally they recommend that you claim 9 allowances (the equivalent of $0 withholding) and then an added dollar amount equal to the total withholding you want per paycheck. This can be a much easier way to control your withholding without having to follow the IRS payroll withholding charts. Again, make sure you contact your payroll department first to make sure they can accommodate these types of requests.

Many people find themselves spending their big tax refund every year instead of saving it. The above approach is a good way to force yourself to save. You’ll find that automatically investing the increased amount of your paycheck each pay period will prove to be an easy way to set aside funds for retirement, college, or your next car. And, don’t forget to change your withholding back to an appropriate level when the New Year comes.


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