We are half way through 2011 already. Folks who filed extensions for the 2010 tax return must have those filed by October 15, 2011, but I am already going to start in on making sure you are in good stead for the upcoming 2011 filing.
Some people like to get a refund from the United States Treasury from their tax return. This isn’t free money. This “refund” comes from an overpayment of the tax amount due for the tax period. This is usually due either to overwithholding from wages or from refundable credits, including the Earned Income Tax Credit for low income earners, usually with dependent children. Since the IRS does not give you interest on money that you overpaid through the course of the year, you are better off to properly withhold throughout the year and get a smaller refund on your return. By properly withholding for your tax situation, you have potentially more money on your pocket each payday, rather than getting the larger refund at the end of the year. If you took that same amount in excess withholding and put it in a savings account or CD, you would be earning interest on your money. If you went one step further and put that same amount in an IRA or 401K/403B type retirement investment account, you would not, per se, have access to the money throughout the year, but you would potentially reduce the amount of taxes you owed, and so possibly increase your refund again!
If you have owed for the previous year or more, then you are likely underwithholding or not paying enough in tax deposits over the course of the year. This is a harder situation to fix, since there is no refund coming to help cover the debt to Uncle Sam. You have to increase your tax withholding, which will lower your paycheck, or you have to start or increase your Estimated Tax Payments. Trust me- it is easier to do this now and have some time to adjust and make a plan, than waiting until the end of the year and realizing that you owe more than you can comfortably come up with by the IRS deadline.
If you have gotten a small refund or owed only a small amount (say $100 or so in either direction), you are the golden child- go to the head of the class, put a star on your paper, have a cookie, and be happy that you are exactly on target in regards to your tax situation. This is really the ideal- and it is a rare situation. When you consider all of the moving targets that make up a tax situation, any change can throw off your tax planning for the year. Some factors that impact your taxable income can include:
- changing jobs
- having more than 1 job reported on the tax return
- changing filing status (single, married filing separate, married filing joint, head of household, or widow/er)
- adding or removing a dependent
- receiving or paying alimony (but not child support)
- moving/changing states
- buying a house
- major medical expenses paid in any tax year
- interest or dividends
- capital gains or losses
- education credits
- Earned Income Credit
- unemployment income (which is still taxable income)
- and many others
So how does the IRS expect you to have the right amount of taxes withheld from your pay? A good place to start is to complete the W4 form for your employer, complete a new one anytime you have a change in status, and check what you have on file at the beginning of each year. Please understand that this form can often be wrong if you have other sources of income or if you have other credits or deductions which lower your taxable income. Also note that the number of dependents for the W4 form are for the HOUSEHOLD, so if you are married and have 1 child, you and your spouse have a TOTAL of 3 which can be 3 for you and 0 for your spouse, 2 for you and 1 for your spouse, etc. State information may vary and you can withhold differently for the IRS and for your state, if required. For detailed instructions and for help with the more complex situations, see IRS Publication 919- How do I Adjust My Tax Withholding.
Another very useful tool is the IRS withholding calculator. By using your previous year return and you most recent paystub from all W2 wage earning positions, along with some estimates for anything else that might affect your tax situation, you can get an estimate of the total taxes you will need to have paid for the current tax period. Now that we are half way through the 2011 tax year, the calculator can be pretty accurate if you don’t expect any changes. This is a free and easy tool to estimate your tax burden, and I recommend you use it as a mid-year check up, as well as any time you have changes. I also like to run the same calculator about the end of October to make sure that if I need to change my withholding up or down before the end of the year, I can do so without completely throwing off my holiday season budget.
Some types of income don’t automatically suggest or require tax withholding, like retirement income. There are tools to calculate what you might need to have withheld there, too. For example- former military or government employees can use the Office of Personnel Management Federal Tax Withholding Calculator. This works much the same as the IRS withholding calculator discussed above. I also mentioned earlier that unemployment income is potentially taxable income. Remember to include any unemployment income in your tax calculations if it is applicable to your household.
Now, changing your withholding will change your take-home pay amount. If you want to see how this will affect your actual paycheck, you will need to run a different kind of calculation. A free salary or hourly wage calculator can give you a pretty good idea of how any deductions, including changes to tax, will affect your paycheck, regardless of how frequently you are paid. DO make sure that you are as accurate as possible with what you are using in the calculator- remember that these estimates are meant to be just that- estimates, but can only be as good as the information you put into the calculator in the first place. If you take the time to do it using your current withholding and deductions, you can see how close it comes to your actual paycheck amount. Then you will have an even better idea of how close the changed situation paycheck estimate will be.
Having at least a basic idea of your tax situation makes good financial sense. Take 20 minutes out to give yourself a summer check-up. You may be very glad you did.