Sunday, January 15, 2012

Adjusting Withholding Allowances on the IRS W-4

Is Getting a Big Income Tax Refund a Good Idea?

U. S. Income Taxes that are withheld in excess of the tax liability are refunded each year. Some taxpayers intentionally overpay their taxes to get a large refund.

In the United States, persons who are employed are required to file a W-4 form with their employer. The form provides information on the employee, including social security number, name and address, as well as tax information.

The W-4 includes how many withholding allowances the employee is claiming and marital status. This choice, along with their wages earned, determines how much tax will be deducted from the paycheck. Allowances are similar to exemptions on the tax form, but do not have to be the same. For instance, the taxpayer can claim zero allowances even though they claim an exemption on the return.

Underpaying Income Taxes

Claiming too many allowances will result in underpayment of tax. Significant underpayments are subject to penalties and interest. It is therefore important to claim enough allowances, or to make estimated payments.

Overpaying Income Taxes

Claiming fewer allowances, or withholding additional tax than necessary to meet the tax obligation, will result in a refund. Some taxpayers intentionally claim more than necessary in order to get a large refund. The reason for this is to get a large amount of money at one time. Receiving the money spread over the whole year may result in the money being spent, not saved. For example, a $2,600 refund may get deposited for a special occasion, but $50 a week may just be put toward the bills.

The standard response for those getting a big refund is that they “are giving the government an interest-free loan” since the there is no interest earned. To some employees, a forced savings program may be an advantage over earning a few pennies in interest.

The Withholding Impact of the 2009 Stimulus

For taxpayers earning less than $75,000, the IRS will be reducing taxes with the Making Work Pay Tax Credit in the American Recovery and Reinvestment Act of 2009 (the 2009 Stimulus). There will be credits of $400 to $800, depending on income. In order to accomplish the goal of stimulating the economy, the tax tables will be adjusted for the credit some time in spring.

Taxpayers who do not adjust their W-4 will receive more in their paychecks, and can anticipate the same refund that they would have gotten without the stimulus. If taxpayers adjust their W-4 to receive the same amount of taxes taken out, they would receive a larger refund. The government allows taxpayers to adjust their W-4s at any time, although employers may have restrictions on how often they can be changed.

Taxpayers should determine how important refunds are compared to having the cash in their pockets. Underpaying carries great risks, but wisely choosing withholding allowances can result in bigger paychecks and the option of stimulating the economy.

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