Should you adjust your tax withholding?

Now that tax day has passed, chances are you’re either waiting patiently for your 2011 tax refund to arrive, it’s already been spent, or you just wrote the U.S. Treasury a check and are in budget-cutting mode.

It’s difficult to calculate exactly how much you’ll owe in taxes unless your income and family situation are identical from year to year. But going more than a few hundred dollars above or below your final tax bill is not a good idea: A big refund means you’ve been giving the government an interest-free loan, while significantly underpaying means you may have to pay costly penalties and interest on
the amount.

Your goal should be to receive little or no tax refund. Better to use that money throughout the year to pay down credit card balances or other debt, build emergency savings, beef up your retirement plan contributions, or invest it where you can earn interest or dividends.

Unless you’re self-employed, retired or had unexpected sources of income, the driving factor for how much tax you owe or have refunded is probably your W-4 form. That’s one of the many forms you filled out your first day on the job and probably never thought about again.

To refresh your memory: IRS Form W-4 determines how much federal income tax is withheld from your paychecks. The more allowances you claim on the W-4, the less income tax is withheld each pay period. When you file your yearly tax return, the government basically settles accounts with you: If they took out too much during the year, you get a refund; not enough and you pay additional taxes with your final return.

It’s a good idea to review your W-4 each year in case your financial or family situation has changed. For example, if you or your spouse:

• Experience a significant increase or decrease in income
• Add a second job, start or stop working (including retirement)
• Have a child (including adoptions)
• Reduce or increase how many dependents you’re claiming
• Get married or divorced
• Buy or sell a house
• File for bankruptcy
• Increase or decrease income adjustments for IRA/401(k) deductions, student loan interest payments or alimony
• Significantly change your itemized deductions or tax credits

If you have a sizeable change in taxable income not subject to withholding (e.g., self-employment income, interest, dividends, capital gains, retirement distributions), you may want to either increase the amount withheld from your paychecks or make quarterly estimated tax payments. Otherwise, the IRS may charge you an underpayment penalty come next April. Estimated tax rules are fairly complicated, so refer to IRS Publication 505
for details.

Ask your H.R. department for a new W-4, or download the IRS version that lets you enter your information electronically and print out a copy (search www.irs.gov). The form contains worksheets for calculating personal withholding allowances and estimating income adjustments if you plan to itemize deductions.

Generally, you’ll claim one allowance for yourself and one for each of your dependents. However, you can adjust the number to avoid having too much or too little tax withheld from your pay.

If you need additional help with the calculations, see IRS Publication 919, use the IRS’s withholding calculator, or use the calculator found in most tax preparation software packages.