Wednesday, September 3, 2008


Q. I've been a taxpayer doing my own returns now for over thirty years, and it's getting to be a drag.
But that's not my question.
It's the end of August and I stare at my and my spouse's pay stubs thinking, "I think they're taking out way too much". What is the best way to correct the W4 mid-year and still minimize tax liability without having a big refund?
I already checked out the neat tool at that you recommended on your blog, but it doesn't have a box that says, "and from your pay stubs, how much have they already carved from your hides?" entry. Barring disaster, our incomes are predictable, as are our itemized deductions, number of kids, and unearned income (interest, etc.).
In the past I've tried tinkering mid-stream, but - as has happened this year - I forgot to reset come January. So, to be specific, I have a W4 that says, "Exemptions/Allowances - US: 9 $280". Yes, 9 plus an additional $280 bi-weekly.
For 2007 I got back over $1000 from the Feds, and owed about that much to my state (which is not NJ, so I won't trouble you with that). I suppose the meta-question might be: why do we play with this exemptions/allowances number instead of a fixed number of $ - or a fixed percentage - to withhold?
In these tight times I am trying to keep good cash flow while still meeting the IRS requirements. It's tricky. Any thoughts you can offer are most welcome.”
A. A few items first –

(1) Withholding has absolutely nothing to do with tax liability. Your tax liability is the tax calculated on income, deductions and credits. Withholding is used to pay your tax liability.

(2) Claiming 9 withholding exemptions plus having an additional $280 withheld makes absolutely no sense. The only time you should request an additional $ amount to be withheld is if you are claiming “0” withholding allowances.

(3) The more withholding exemptions you claim – the less the federal income tax withholding. To have additional monies withheld you would not add a $ amount, you would reduce the number of exemptions.

(4) To avoid incurring a penalty for “underpayment of estimated tax” you must have either 90% of the final current (2008) tax liability, or 100% of the prior year’s (2007) tax liability (110% if your 2007 AGI was more than $150,000), paid in during the year, either by withholding or quarterly estimated taxes.

(5) Withholding is assumed by the IRS to be made evenly throughout the year regardless of when the money is actually withheld – unless you wish to show the actual withholding per quarter when attempting to avoid the penalty for underpayment of estimated tax by “annualizing” your income.

It appears that you want to pretty much “break even” with Sam (and I expect your state as well) when you file your 2008 Form 1040. Here is what you should do –

Using the 2007 Form 1040 as a formatting guide, and the information for 2008 deductions, etc. available on the “What’s New for 2008” Page at my website, prepare an estimated 2008 income tax return. You indicate “our incomes are predictable, as are our itemized deductions, number of kids, and unearned income”, so that should not be difficult. You want to come up with an estimated 2008 tax liability (my “What’s New” page also has the 2008 tax rate schedules).

Now take your latest pay stub(s), with cumulative year-to-date information, and determine the total federal income withheld to date. Subtract this number from the estimated 2008 tax liability – this is the amount of federal income tax you need to have withheld from your wages for the rest of 2008.

Next divide the balance of the tax withholding needed for the year by the number of remaining pay periods and you will come up with the amount that you need withheld from each check. Remember that once you submit a revised Form W-4 to your employer it will probably take one or two pay periods for the change to “kick in”.

Click here to download the 2008 IRS “Employer Tax Guide”, which has the various federal income tax withholding tables (Pages 40-59) based on pay period (I assume bi-monthly in your case) and withholding status. If your pay is the same each paycheck you will be able to determine the correct number of withholding allowances to claim so that the proper amount of federal income tax is withheld.

You should also be able to use the tool you mentioned at to determine the number of allowances with this information.

If you are claiming “Married” on your W-2 you should be aware that you can have your withholding done under the Single tables by claiming “Married – but withheld at the higher Single rate” on your W-4.

For 2008 each withholding allowance you claim is the equivalent of $3,500 (the amount of a personal exemption) in additional deductions. So if you are in the 25% tax bracket each withholding allowance represents $875 in federal income tax for the year – or about $33.65 per each bi-weekly pay period.

Of course if you increase your number of exemptions for the last months of the year by submitting a revised Form W-4 don’t forget to submit a new Form W-4 at the end of December so you “go back” to normal in 2009. Ideally you will want to determine the correct number of withholding for the year from day one so you do not have to change your W-4 during the year.
As for “why do we play with this exemptions/allowances number instead of a fixed number of $ - or a fixed percentage - to withhold?” – good question. Withholding on pensions often uses a flat % method.

BTW – if doing your own tax returns is getting to be a drag why not use a competent tax professional!

I hope I have been of help.


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