The tax mistake that could hurt you now or next year

admin May 19, 2015 Budgeting, taxes

This article is by staff writer Suba Iyer.

Presumably, it has been a little more than a month since you submitted your tax return for 2014. Did you end up owing the IRS or did you get a refund? There are plenty of personal finance articles that discuss the pros and cons for each of these situations. So we will skip those discussions and go right to the point: Are you happy with your result?

If not, you can easily fix it for next year by adjusting your withholding now. But it’s a simple step many people forget to take.

Now or next year?

For example, if you got a refund this year but would rather have more money each month to help your cash flow, adjusting your withholding now could fix that. On the other hand, if you wait or forget, you lose the benefit of better cash flow for the rest of the year.

If instead you ended up owing a lot this year and you don’t want to experience that again (or run the risk of incurring a penalty), this is the time to adjust your withholding to prevent that. Here again, waiting to make this simple change could leave you in the position of scraping together enough money to pay your tax liability next year.

How do you adjust your withholding?

Overly simplified answer: If you are a W-2 employee, you would fill out a W-4 form (also called “Employee’s Withholding Allowance Certificate”) and submit it to your employer. This form, along with your basic information, has two important pieces of information that guide the employer on how much they have to withhold from your paycheck to send to the IRS:

The number of allowances you want to claim (the higher the number, the lower the taxes withheld)
Additional dollar amount you want to withhold.

Think about the future.

It is a single form, but you need to do some work before you complete it. There are some questions in the form that will guide you to the right withholding, but you need to think beyond the obvious questions on the form.

For example, the form asks for number of dependents. Will that change in the coming year? Even if you have a baby on December 31, you can claim him/her as a dependent for the whole year.

Are you planning to get married later this year? You can go ahead and fill out the form as “married” to reduce the withholding.

Explore the form in its entirety.

It helps to walk through different scenarios and future events you think could happen later in the year to figure out the closest withholding amount. You might never have claimed any itemized deductions before; but if you are in the market for a house in an area with a high cost of living, you might want to try filling out the “Deductions and Adjustments Worksheet” on page 2 of the W-4 form. This form includes the usual deductions found in Schedule A of Form 1040. Every $4,000 of deductions equals one extra allowance in the W-4 form.

If you are in a two-income household, there is a little more work to be done. Fill out the “Two-Earners/Multiple Jobs Worksheet” on page 2 of the W-4 form.

Prefer to do this online?

If you don’t want to work on a paper form and would prefer an online calculator, check out the IRS withholding calculator. It will ask similar questions to the form and spit out the number you should write down in your W-4 form to submit to your human resources department.

What if you are self-employed?

If you are a self-employed taxpayer, you have a lot more power on how much you pay quarterly. You can start by dividing the amount you owed the previous year by four and send that amount to the IRS for the first quarter. As you know more about your income for the current year, you can increase or decrease the amount you send in for each of the following quarters.

Another way to handle withholding your own taxes is, if your spouse is a W-2 employee, you can adjust his/her withholding (withhold more than necessary to cover your portion of the taxes). The plus side of this method is that you don’t have to worry about sending in quarterly payments, but the down side is that you can’t be very flexible based on how your income fluctuates during the year because you have to fill out a new W-4 each time you want to change your withholding.

If you fill out a W-4, are you assured your withholding will be as close as possible to what you will actually owe next year?

No, not exactly. Here are some other factors that contribute to how much you owe in taxes:

Did you have income other than your W-2?
Did you get a lot of dividends?
Did you sell (or are you planning to sell) any stock?
Did you end up unemployed for any period of time during the year?

All of these situations will affect the amount of tax you ultimately owe. If you end up earning a lot more than what you originally anticipated when you filled out the W-4 form, you are likely to owe the IRS — and vice versa (if you end up earning a lot less, you may get a refund). It is OK to owe a little. The important thing is to avoid a penalty.

How can you avoid a penalty?

According to the law, there is no penalty if:

You owe less than $1,000 in tax after subtracting the withholding and estimated tax payments, or
You paid at least 90 percent of the tax for the current year, or
You paid at least 100 percent of the tax shown on the return for the prior year.

When can you adjust your withholding?

You can adjust your withholding any time of the year. Of course, if you make changes later in the year, it will have less of an impact on that year’s taxes. Also, any time your life situation changes — you get married, buy a house, add a new dependent — it is a good idea to review your withholding amount and decide whether you should adjust it.

Whether you want to be on the forced-savings side or the not-giving-the-IRS-a-free-loan side with your tax return, the key step is to adjust your withholding now — and hopefully now you have all the information you need to make your choice a reality.

Have you changed your withholding to free up cash flow or avoid getting a penalty? How often do you adjust your withholding?