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How to Properly Adjust Your Federal Income Tax Withholding Allowances

By Casey Slide

form w4 tax withholdingMy husband and I recently did our taxes, and we were shocked by the amount of money we were being refunded by the government. At first we were elated because it was enough to pay off our car, so that we would now be able to live debt free. At the same time, we were kicking ourselves for not having this money available for use during the past year.

Maybe you’ve had a similar experience – or the opposite (and decidedly less pleasant) one where you’ve had to pay more money in federal taxes than you expected. Regardless, the issue is the same. In both these situations, the amount of taxes being withheld from your paycheck is not coinciding with the amount of taxes that you are required to pay. The best way to fix this is to adjust your federal tax withholdings, which you can do in a few simple steps.

But first, let’s look at how to decide if you need to make an adjustment.

When Should You Adjust Your Tax Withholding?

1. You Got a Big Refund
If you received a large tax return from the IRS for last year’s taxes, that means too much money was being taken out of your paycheck. Sure, it’s exciting to get a big check, but think of it this way: this is money that belongs to you that you were essentially loaning to the government interest-free. If you were not loaning it to the government, not only could you have used that money throughout the year to pay for your expenses, but you could also have invested it and received interest on it. It’s great when you can do something smart with your tax refund, but it is not the best financial situation.

Let’s say for example that you got a refund of $1,000. You gave the government $1,000, and the government gave you back $1,000. Had your tax withholding been correct, you could have invested that $1,000 at a 5% interest rate and then you would have at least $1,050. That’s a profit of $50 that you are losing out on by loaning money to the government.

2. You Owed Money
It sure is an awful feeling when you owe a large amount of money to the government, especially if you thought you might be getting a refund. But just like with anything that you must save up for, you need to put a little extra money aside with each paycheck to pay for a big expense. In my experience with budgeting with the 5S system, the best way to do that is to not have the money in your possession at all. Out of sight, out of mind. Increase your withholding so that the government gets the money before you receive it.

For example, if you owe $1,000, and you get paid weekly, you can spread that $1,000 out over 52 weeks. So instead of owing the government $1,000 in one lump sum, give them an extra $20 each week to avoid owing when you file your taxes.

3. You Are Expecting Life Changes
When your life changes, so do your taxes. Did you get married? Have a baby? Buy a home? Start giving charitable contributions? Are you expecting any of these changes in the coming year? All of these things will affect your taxable income so take the opportunity to review your tax withholding.

How to Adjust Your Federal Tax Withholding

To adjust the amount of taxes withheld from your paycheck, the first step is on you, and the rest is on your employer. You must determine the number of tax withholding allowances so that your employer can use that number in tables provided by the IRS to know how much tax money should be withheld.

But how do you determine the number of allowances? Below are a few helpful calculations. I recommend using a couple of the methods and comparing results so that you can be confident in the number of allowances that you are submitting to your employer. Tip: Before you get started, have your previous year’s tax documents handy as well as your last pay stub.

1. W-4 Form Personal Allowance Worksheet
Too many of us skip right over the worksheet portion of our W-4s and go straight to the part that needs to be filled out for our employer. When I was younger, I actually had an employer tell me not to worry about the worksheet portion and to just put zero in for the number of allowances. However, the W-4 Personal Allowance Worksheet can be very helpful, especially if you are not itemizing and only have one source of income.

I used the W-4 Form as one way to determine our correct number of allowances, but since I needed to itemize, I found the Deductions and Adjustments Worksheet found on page 2 of the W-4 Form to be a little more involved. I had to find a copy of Publication 919 in order to determine if I had any additional tax deductions or credits. In Pub. 919, you will need to use Worksheet 2 on page 12 to answer Line 4 of the Deductions and Adjustments Worksheet, and you will need to use Worksheet 8 on page 17 to answer Line 5.

2. IRS Withholding Calculator
This calculator can be found on the IRS website and is very simple to use. I actually spoke to someone from the IRS when I was researching how to adjust my withholding allowances, and this was their recommendation to me. To use the calculator, you will need to answer a series of questions about your marital status, dependents, and income. This is where having your previous tax documents and last pay stub will come in handy. If you plan to only use one method, this is what I would recommend due to the ease of use.

3. Manual Calculation
The number of allowances that you should have is approximately equal to your total tax deductions divided by the personal exemption amount ($3,700 for 2011). For example, a husband and wife married filing jointly who have one child would have a standard deduction of $11,600 and 3 personal exemptions at $3,700 each. Therefore, the total tax deductions would be $11,600 + ($3,700*3) = $22,700. Divide that by the personal exemption amount and that equals 6.1. So for this example, 6 allowances should be claimed.

To do this calculation yourself, follow these formulas:

Total Tax Deductions = Standard Deductions (Pub. 919 Worksheet 2 Page 12) + Personal Exemptions (# of people * $3,700)

OR

Total Tax Deductions = Itemized Deductions + Personal Exemptions (# of people *$3,700)

Allowances = Total Tax Deductions / Personal Exemption Amount ($3,700 for 2011)

4. Work Backwards
Another manual calculation that you can do is to back in to how many allowances you should have based on how much taxes you project to owe. The first step is to plug in estimate values in the following formula to determine your taxable income:

Gross Pay – Standard Deductions (Pub. 919 Worksheet 2 Page 12) - Personal Exemptions (# of people * $3,700) = Taxable Income

OR

Gross Pay - Itemized Deductions - Personal Exemptions (# of people * $3,700) = Taxable Income

Next, go to the tax table for this year to determine how much you will owe for the year. Divide that number by the number of paychecks you will receive to determine how much you should pay in taxes per paycheck. Then meet with your payroll department to see if they can help you determine the number of allowances you need to make sure that amount is taken out per pay period.

Here is an example: Let’s say you are single. If your taxable income is $30,000, then according to the tax table, you will owe $4,085. If you are paid weekly, you will need to pay $4,085 / 52 = $78.56 per week.

5. Be Logical
If you want the easiest way, yet least accurate, of calculating your withholding allowances, just count them up in your head. Count one for each person in the family, count one for owning a home, and count another one if you want to be a good steward by making charitable contributions. You may have a return or you may have to pay, but each year, make an effort to get closer to the break even point.

Final Word

To get the most accurate answer on adjusting your federal tax withholding allowances, try a couple of the above methods to see if they all come out approximately equal. There is no need to try all of them unless you enjoy math and finding the exact answer, like I do. I honestly had a little bit of fun, especially since using all of these methods, I was able to come up with the same number of allowances, give or take 1. I now feel confident in the number of tax withholding allowances we have for this new tax year – and you can too!

Have you made an effort to adjust your tax withholding yet?

(photo credit: Shutterstock)

Casey Slide
Casey Slide lives with her husband and baby in Atlanta, GA. She graduated from the University of Florida in 2005 with a bachelor’s degree in Industrial Engineering and worked for a prominent hospital in Atlanta. With the birth of Casey’s son in February 2010, she decided to become a stay-at-home mom. Casey’s interests include reading, running, living green, and saving money.

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  • Gerry

    And where did you find a place to invest 1,000 at 5%?

  • David M

    Gerry – that is were I was going as well.

    Casey – people are always going to find the weakest link in any argument and pounce all over that – I recommend in the future that you stick with facts and don’t put unrealistic numbers in your examples.

    Also, many people in America budget totally different from you and me! They pay what they need to and spend the rest! I know that sounds crazy to you! However, it is true, thus, the best thing for them is to get a BIG refund from the IRS and then save the money the government “gave them”.

    I intentionally over pay each year and I’m a CPA and know all about the time value of money. Why do I overpay on purpose, well my wife is self employed and REQUIRED to pay quarterly taxes. I do not want to deal with the paperwork. Thus I have extra $ taken from my taxes and if the IRS ask about the quarterly taxes not taken out – I will tell them to penalize me for the underpayment. Since I have no underpayment – they are not going to penalize me.

  • Casey Slide

    Gerry and David – I thought there would be a chance that someone would say something about the 5%. I just wanted to demonstrate the concept and use a nice, easy-to-use number and keep the focus on the federal income tax withholding process and the fact that you could be doing much better with your money than giving an interest-free loan to the government. Thanks for your feedback.

  • david m

    One more comment from a CPA – the average amount that you would have invested on that $1,000 return – would be $500. Thus even at 5% the profit would be only $25. I’m assuming you would lower the amount being taken out of you pay be the same amount each pay period. Liike a said I’m a CPA – Certified Pain in the *ss. :)

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