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Thursday, October 12, 2006

Get next year's tax refund now

Get next year's tax refund now
The lowly W-4 form you sign when you take a job can be a powerful tax-planning tool that can put cash in your wallet now. Here’s how to make work it for you.

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By Jeff Schnepper
How'd you like to put more money into your pocket now? If you're an employee, it's really easy.

When you started working, your employer asked you to complete a Form W-4 -- the Employee's Withholding Allowance Certificate. From your answers on the form, your employer determines how much to withhold in federal and state taxes.

I admit that the phrasing is arcane: The form asks how many "withholding allowances" you want to claim.

But here is the bottom line. Withholding allowances equal cash. The more "allowances" you claim, the less taxes are taken from your paycheck. And that means more cash comes to you each pay period.

Signing the W-4 the first time doesn't lock you into one set of allowances forever. In fact, federal law requires your employer to let you change your allowances at any time. Again, increase your allowances, and you increase the amount of money you take home now. Here's how:

The family. You get an allowance for each exemption you claim on your tax return -- for yourself, your spouse and your dependents. Unfortunately, that's where most people stop, and they over-withhold.

Tax credits. You can get additional withholding allowances for the estimated tax credits you expect to take. If you expect to qualify for the earned income credit, the credit for child and dependent-care expenses, the foreign tax credit, the child tax credit, education credits or adoption credits, these all permit you to claim additional allowances
Business expenses. You can get additional withholding allowances for employee business expenses, moving expenses and, if you qualify, for the additional standard deduction for the aged or blind.

Estimated business losses. You can get additional withholding allowances for estimated net losses from your business or profession, from capital losses, from losses on rental properties and from losses from farming expenses
IRA contributions. You can get additional withholding allowances for potential contributions to a deductible IRA.

Itemized deductions and alimony. You can get additional withholding allowances if you expect to itemize your deductions and/or pay alimony during the year.

Itemized deductions give you possibly the biggest opportunity to put a lot more into your take-home pay. The key is expected, not actual, deductions, contributions and losses. Additional withholding allowances can always be claimed under the expectation of making charitable contributions, incurring higher medical expenses or borrowing money and incurring an increase in interest expenses.

Why reduce your withholdings?
The advantages of reducing your withholdings can be significant. If you're single and earn $20,000 a year, one additional allowance that you claim reduces the withholding taken from your salary by about $40 a month. That adds up to $468 a year. With five additional withholding allowances, you have an additional $2,300 every year in your pocket.

Understand that reducing your withholdings does NOT reduce the tax you have to pay on April 15. (Or more correctly for the 2006 tax return you will file in 2007 -- April 17.) What it does do is put more money in your pocket now, rather than later in the form of a big refund.

Psychologically, it's great to get the big refund after you file your return. But think about it: a big refund means that you've given an interest-free loan to the IRS. They, not you, have had the use of your money during the year.

The objective you should focus on: Give the IRS just enough money so that you avoid any penalties. That way you have the use of the money during the year -- and any interest earned on those "extra" dollars belongs to you.

You can avoid any under-withholding interest or penalties in 2005 if you meet any of the following safe harbors:

Your net tax due is less than $1,000, or

You've paid in at least 90% of your total tax due for the year, or

If your prior year's adjusted gross income wasn't more than $150,000, and you paid in at least 100% of your prior year's total tax, or

If your 2005 adjusted gross income was more than $150,000, then for 2006, you must pay in at least 110% of your 2005 income tax bill. If, for example, your adjusted gross income exceeded $150,000 in 2005 and your TOTAL 2005 tax was $20,000, you can avoid any interest or penalties for 2006 if you pay in at least $22,000 -- 110% of the $20,000.

No matter how much you may owe on April 15, if you meet any of these safe-harbor requirements, you escape all under-withholding interest and penalties.

In the worst-case situation, you can take the "extra" dollars and put them in a money-market fund each pay period. This cash will be there on April 15 if taxes are due, and at least you've earned some incremental dollars in interest.

Don't forget: you may file a new W-4 form at any time if you want to change your withholding allowances, for any reason. This gives you another opportunity for tax savings.

Unlike estimated tax payments, which are always due on specified dates (April 15, July 15 and Oct. 15, and Jan. 15 of the year following), payroll withholdings are expected to be paid evenly throughout the year. Some sophisticated, tax-knowledgeable individuals significantly under-withhold on their income for the first 11 months of the year, file an amended W-4 and then significantly over-withhold in the last month to make up the difference.

As long as you meet any of the safe harbor rules we discussed, you escape interest and penalties for under-withholding.

So take a look at your W-4. I'll bet you'll be glad you did.

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