Federal Tax Withholding: Keep it Under Control! (Income Tax Write- Off)
Apr 16 '02 (Updated Jul 14 '09)
The Bottom Line An individual should strive to keep federal tax withholding at a level no greater than the amount necessary to pay his/her annual tax liability.
Note: This Epinion is being submitted as part of a special Income Tax write- off, hosted by financial gurus Arthur.Rubin and laura10801. Read and enjoy!
April 15, is a day that many Americans dread. It's a day full of stress and chaos. The post offices are open later than usual, in order to handle the surge of last- minute mail. Protestors greet each customer with handout literature. Employees at financial service companies are forced to work overtime to handle the barrage of last- minute phone calls on this special day.
The reason for the mayhem? It's tax day in the United States of America!
For many Americans, this is the last day to get the income tax filing completed, in order to avoid paying any penalties. Some people put off filing until the last minute, usually because they owe money and they see no reason to hurry along, when the end result is the fattening of the IRS coffers.
Some individuals have their federal tax withholding set high, so that they get a refund at tax time. Others have it set low, in order to come as close to "breaking even" as possible. Is one method better than the other? Should we all strive to have excess money withheld, and then receive a refund, or is it better to have the excess cash available in each one of our paychecks? Let's examine the issue of federal tax withholding.
History of Federal Tax Withholding:
Payroll tax withholding of federal taxes began in 1943, when congress passed the Current Tax Payment Act. Before this act was made law, individuals would fill out their tax returns and mail in their payment. There was no federal withholding. You would just compute the tax that you owed, and mail in the amount due to the IRS. The Current Tax Payment Act was passed in order to ensure that the funds kept flowing in. To sell the idea to the naïve members of the public, government officials touted this new withholding as a boon to taxpayers because it would make it much easier and less stressful to pay Uncle Sam his annual dues. Of course, the real reason for federal withholding was to make sure that there would always be a constant flow of tax revenue. Without withholding, the politicians worried, taxpayers might revolt and just refuse to mail in their annual tax liability payments.
How Does Federal Withholding Work?:
When a company hires a new employee, he/she is asked to fill out a W-4 tax withholding form. Among other things, this form will ask you, the taxpayer, to indicate the number of federal exemptions that you wish to claim, along with your tax filing status (married, single). Based on your answers to these questions (and others) the payroll office at your place of employment will have the information necessary to start processing your paychecks and determining the proper amount of federal tax withholding.
Unless you specify a special method of federal tax withholding (the options vary from one employer to the next), you can safely assume that the federal tax tables will be used to compute your taxes. If your filing status is single, you can expect your tax withholding to be greater than if you file as married (assuming everything else is equal). You will also experience greater federal tax withholding if you claim fewer exemptions.
Federal tax tables are designed in such a way that, more often then not, you will have excessive federal taxes withheld. This is especially true if you work in an occupation where your earnings fluctuate widely. If you get a constant salary amount, your federal withholding will remain steady throughout the year. However, if you receive other forms of income (like sales commissions) you will notice that the federal withholding is often disproportionate when you make a large sum of money. The reason is because the federal tax tables, when they make the computation of tax, assume that the taxable gross that you just earned is your normal rate of pay. It doesn't matter if it really is your normal rate or not. The tax table assume that it is normal, and it withholds the tax that would be expected for someone who makes that level of pay on a constant basis. For example, if you are a single salesman who claims zero exemptions and makes a weekly draw of $500, your federal withholding on the weekly pay might only be $60. However, if you get a commission check for $2,000, and your payroll office processes the pay based on your normal pay type (weekly, in this example), you can expect your federal tax withholding to increase exponentially, up to nearly $500 dollars. Your gross pay has increased only four times, but your federal withholding has gone up by more than eight times. That's because the higher rate of pay has placed you in a higher tax bracket, based on the assumption that this is your normal rate of pay. It really isn't, but that's how the federal tax table works.
Refund vs. Owing Money:
When it comes time to compute your tax liability, the majority of Americans end up with a small refund of the excess taxes withheld for the past year. Most people, when they fill out the W-4 form, enter the number of exemptions that corresponds to the size of their families. This ensures (barring any excessive investment income and other factors) that the individual will have excess federal tax withheld and will receive a refund from the IRS.
Many people like getting refunds. They enjoy the "surprise" money that arrives in the mail in the late winter or early spring. This might seem nice, but the truth is that the individual would be better off reducing the amount of payroll tax withholding and investing the excess money out of each paycheck. There are numerous reasons for this, but the main reason is that excess withholding is basically an interest- free loan that you are giving to the government. The excess withholding could have gone into your savings account, or some other investment. Instead, if you give it to the IRS, it will sit idle until you receive a refund, at tax time.
Some people are deceived by tax refunds. They get the IRS check in the mail, and they react like they just won a cash prize in a small sweepstakes. They think this refund is a "gift" from the IRS. Of course, it is actually nothing of the kind. It's just a refund of your own money that was excessively withheld over the past year.
How do I Determine the Proper Amount of Federal Withholding?:
If you want to change your withholding rate so that you end up as close to the break- even point (zero tax refund) as possible, you first need to estimate your tax for the year. You can utilize many of the helpful on- line resources to assist you in estimating your tax, or you can hire a tax professional.
Once you have an estimate, you should then divide this amount by the number of pay periods that you receive paychecks each year. This will provide an estimate of the necessary federal tax withholding that you need each pay period, to satisfy your tax liability for the year.
Now that you have your estimated per- period federal tax amount, take a look at your pay stub. If the estimated amount is less than your withholding per pay period, you can then request to increase your federal exemptions claimed, on the W-4 form. This will lower the amount withheld per check, putting more money in your pocket now, and reducing your refund.
Let's take a look at an example. Suppose that you are single and you make $1,000 taxable gross every two weeks (26,000 annually). You estimate that your tax liability for the year will be $2,000. Dividing this amount by 26 pay periods, you need $76.92 of tax withholding to exactly cover your tax liability. Your tax withholding, at different exemption levels, would be as follows:
# of Exemptions Claimed..........Federal Tax Withheld
0.......................................................$123.37
1.........................................................106.06
2..........................................................88.75
3..........................................................71.44
Using this example, this individual could claim 3 exemptions, to minimize the withholding and maximize the net pay received with each paycheck. When tax time rolled around, this person would owe approximately $140 to the IRS.
Final Thoughts:
Choosing the optimal level of federal tax withholding is usually easier than people think. It's just a matter of estimating the federal tax liability for the year, and then adjusting your withholding to come as close to the break- even point as possible.
Tax refunds might seem like a nice way to force ones' self to save money, but they are, in reality, a bad idea because they allow the government to use your money interest free. This is money that the taxpayer could have used himself/herself, throughout the year, earning some investment return rather than sitting idly in the IRS coffers.
It's important to remember that the federal tax tables are designed to withhold excessive amounts of money. Government designed them this way to result in extra funds for its own use, and to ensure that a large percentage of the public doesn't end up owing federal taxes. But you, as a taxpayer, are not forced to accept the level of withholding that the tax table computes. You can raise or lower your exemptions whenever you wish, to reach the optimal level of withholding.
It's best to keep your withholding minimized, so that your money works for you, and not for the government. Having too little withholding can result in having to pay a penalty (I think the penalty kicks in if your withholding is less than 10% of your tax liability) but there is no penalty for keeping your withholding close to the break- even level.
The 2001 tax season is now behind us. April 15 has passed, for another year. There isn't much that can be done about last year's taxes, but there's plenty of time to prepare for the 2002 tax season. Consult with a tax advisor, or use some of the internet tools that are available, and keep more money in your pocket.
For more tax information, check out these other reviews/essays:
www.moneysavingparent.com
Marginal Tax Rates
Federal Exemptions
Standard Deductions
Short Term Capital Gains and Losses
Long Term Capital Gains and Losses
Capital Losses and Tax Treatment
Charitable Contributions
Interest Income
 |
|
|
|
|
|
|
|
© 1999-2009 Shopping.com, Inc.