If you have been receiving a relatively large tax refund (refund in access of $1,500) in the past couple of years, yet you’re finding it hard to make ends meet. This article is for you.
Nearly 70 percent of Americans are living paycheck to paycheck. After they pay their monthly expenses and debts, they have nothing left over to save and invest for future goals, payoff debt and/or spend on activity that’s conducive toward romance, amusement, and entertainment.
When faced with this dilemma, the obvious answer is to create some wiggle room in the budget. Easier said then done right? One of the strategies that I often advice clients to do when seeking ways to create some extra cash-flow in the budget is to modify their Employee’s Withholding Allowance Certificate—commonly referred to as Form W-4. This strategy should be used only if you’ve been receiving a relatively large tax refund in previous years and your filing status will remain the same going forward.
When you file your tax return for the year, you report all of your income and all of your withholdings and other payments. If you paid more than you had to, as many people do, you will receive a refund of the overpayment. The average tax refund is about $2,500. I’m sure the idea of receiving a lump-sum check of $2,500 sounds great. But if you’re struggling from check to check, it may serve you better to reap the $2,500 year round. A $2,500 refund is equal to an extra $208 in your paycheck per month ($2.500/12-months = $208.33)
Understanding Form W-4
An employee tells his employer how much income tax to withhold from his taxable wages by completing Form W-4. Form W-4 doesn’t actually show the amount of tax to withhold; rather it shows how many withholding allowances the employee is claiming. The employee may determine his allowance by using one of the three IRS worksheets provided with Form W-4. The three worksheets are “Personal Allowances Worksheet”, “Deductions and Adjustments Worksheet” and Two-Earner/Two-Job Worksheet. The “Personal Allowance Worksheet” is the worksheet most commonly used. We’ll focus solely on the “Personal Allowance Worksheet in this article.
The primary reason many people pay more than what is actually owed on taxes is because the number of withholding allowances claimed on form W-4 are often confused with the number of exemptions an employee expects to claim on their tax returns.
Additional withholding allowances are often granted for reasons other than exemptions. For example; a single mom with one child my conclude that when filling out Form W-4 she should claim 2 withholding allowances because she will be claiming two exemptions on her tax return. However, a careful review of the Personal Allowance worksheet will show this single mom can claim additional allowances because there is an allowance awarded for claiming as head of household. There is an allowance awarded if she has at least $1,500 child or dependent care expenses. There is up to two allowances awarded if she will be claiming a child tax credit and her total income will be less than $52,000. So while marking single with 2 withholding allowance on her W-4, this single mom’s W-4 should reflect single with 6 withholding allowances.
The end result—more money being taken out of your paycheck than what you actually owe on taxes. Below is a summary of each line on the “Personal Allowance Worksheet”:
Line A. The employee may claim one allowance for himself, unless someone else will claim him as a dependent.
Line B. The taxpayer may take an additional allowance if the job to which this Form W-4 applies is his only job, if he is filing a joint return and his spouse does not work, or if the income from any other jobs he (and his spouse) holds totals $1,000 or less.
Line C. The employee may add one allowance for his spouse, but may choose not to do so if he has a second job or if his spouse works.
Line D. One additional allowance may be added for each dependent the taxpayer will claim on his tax return. He may choose not to claim all such allowance if he prefers to have additional tax withheld.
Line E. An additional allowance may be claimed if the taxpayer will file using the head of household filing status.
Line F. The employee may claim an additional allowance if he has paid at least $1,500 for child and dependent care expenses for which he will be claiming a credit.
Line G. Depending upon his expected income, the employee may claim up to two additional allowances for each eligible child for whom he plans to claim a child tax credit on his tax returns
Line H. Total lines A through G. This is the number of withholding allowance you’re eligible to claim. Note that this number may be different from the number of exemptions you claim on your tax return.
This worksheet does not take Earned Income Credit into account. If a portion of your tax refund is because you’re eligible for the Earned Income Credit, you can file Form W-5 with your employer requesting an advance on your Earned Income Credit—thus increasing your monthly cash flow.
(Mortgage and Money Coach Damon is the owner of ACE Financial. He can be reached at 412-216-1013.)