It’s Friday, so it’s time for this week’s reader-submitted Q & A. If you’d like to submit a question, click here for more information or simply email a question.
Michael-
I have a question about the W-4 and changing number of exemptions. I graduated from law school in May 2007 and started my salaried position in Nov. 07. So, if I was to change number of exemptions (I used the withholding calculator on your website and it said to change exemptions to “6″) – would I then OWE money to gov. next April instead of getting a refund? Would there be any other foreseeable disadvantages- any tax penalties?
I was just wondering because I have not had the same salary for several years and since I will be making more for 2008 than i did for 2007, would it be smart to change # of exemptions and take more $ now instead of bigger tax refund or could this backfire next April (could i owe a lot of money to government)?
Thanks so much-love your book!
–Renee R., Chicago, IL
STRAIGHTFORWARD ANSWER
Renee, the calculator tells everyone to put in “6″ so I’m not sure what to tell you.
Just kidding!
In determining the number of allowances to use, the calculator attempts to make it so that you will neither owe nor receive a refund.
More Detailed Explanation
This is a great question, Renee. As you’ve learned, consistently receiving an income tax refund is not a good thing. It amounts to you making an interest-free loan to the government. Don’t be so generous. Instead, adjust your allowances so that each one of your paychecks increases throughout the year. By increasing your allowances, you will reduce your tax withholdings. Since your gross pay is the same and now you are having less taxes withheld, you’ll find that your net pay (what you can spend or save) increases!
The calculator at Total Candor seeks to make it so that you’ll neither owe nor receive an income tax refund. Obviously, this is only as good as the assumptions you enter. Since it’s impossible for most people to predict their exact future income tax (i.e, how much interest they’ll earn or the precise amount of deductions they’ll be eligible for), more than likely you’ll owe a little bit or get a small refund come next April.
What about penalties? Interest?
The IRS rules for penalties and interest related to underpaying your tax are actually very simple.
Okay, not really, but I think most people can follow them.
In order to avoid owing any interest or penalties next year when you file, you must withhold from your paychecks at least the lower of the following two figures:
- 90% of your total federal income tax for 2008
- 100% of the total federal income tax you paid in 2007 (You can find this number at line 63 of your 2007 Form 1040. If, however, your 2007 Adjusted Gross Income – line 37 of your Form 1040 – was more than $150,000, then this second figure is actually 110% of your 2007 income tax).
You: Why is this so complicated?
535 members of Congress on the wall, 535 members of Congress. . .
As long as you withhold at least the minimum of those two amounts above, then you will have nothing to worry about with regard to underpayment interest and penalties. However, you could still owe a lot of income tax with your return next April IF you choose to withhold based on last year’s tax and your current year’s income tax is much higher. That’s a sound financial strategy (since it is better to pay later rather than sooner), but you have to be sure to have the money on hand come next April.
Soon, I’ll talk about part 2 of the aforementioned calculator – using it to increase your 401(k) contributions without lowering your net pay.
Tags: Form W4, income tax refund, tax withholding, withholding
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This is a terrific article and really sound from a personal finance perspective.
I want to add one very strong caveat to this however – if you do not have a closed budgeting system where you know where every single dollar is going, DON’T DO THIS because you need a “forced savings” mechanism.
What I mean by closed budgeting is that every dollar you spend is counted in some way. You are not going to best buy and buying a $60 video game “just cuz”. What this also means is that if you over spend in any given month, you are delaying future purchases until you make up for past overspends. It’s not so much a matter of money as it is of time.
Also, I feel like the benefit of giving the government a free loan is somewhat overstated in this article. If you have a $5000 tax refund, you’re talking about $20 in interest with the best online savings accounts right now.
That being said, I completely support the notion of having all of your money at the exact time that you earn it and not deferring it to tax rebates. It’s just that with interest rates being so low at the moment it doesn’t matter nearly as much as it did.
Lastly, contributing more to a 401k is only advisable if you have enough cash in the bank to cover a 6 month unemployment stretch which is an all too real prospect for all of us.