Adjusting Tax Withholding from Your Paycheck

After finishing up your tax return, it's a smart idea to do a little planning ahead for next year. Your income or deductions may be changing, and you may want to adjust your withholding to avoid having too large of refund or a significant balance due. Finding just the right level of withholding can be tricky, especially if you anticipate significant changes to your income or deductions.

Claiming One Withholding Allowance Usually Results in a Tax Refund

Calculating a level of withholding that is "just right" takes me as much time as preparing a tax return sometimes. As a result, some people are inclined the skip the math. For those who want to keep things as simple as possible, the easiest course of action is for taxpayers to claim either Single or Married with one withholding allowance on Form W-4. This usually results in a refund for most people. However, I have seen situations in which claiming one withholding allowance was not sufficient to cover tax liabilities. This seems to be the case in which a person has significant investment income or higher taxes due to the Alternative Minimum Tax. So even people who want to keep things simple and count on a refund should review their withholding at least periodically.

Calculating Withholding More Accurately

The more accurate way to adjust your withholding is to create a projected tax return for this year. You can do this by using the same tax forms you used last year, but substitute the current tax rates. For example, you could calculate your income and deductions based on what you expect for 2012, and then use the 2012 tax rates to find out what your projected tax will be. You can also use the worksheet found in Form 1040-ES, which has formulas for calculating taxes for the current tax year.

After figuring out the tax liability, I then use the withholding calculator found on the IRS Web site to see what the suggested withholding allowances might be. You can also do the math by hand by using the worksheets provided with Form W-4.

What's a Withholding Allowance?

The math for the calculator and the worksheets may seem a bit confusing at first. Basically, these tools are attempting to find your "withholding allowances." Withholding allowances are not the same as how many dependents you have, although the two concepts are related mathematically. A withholding allowance is a way for your payroll department to use the look-up tables provided by the IRS to figure out how much tax to withhold. Roughly, a withholding allowance represents your total tax deductions divided by the personal exemption amount. This results in a ratio, and this ratio is how many withholding allowances you should claim.

Example: Mary is a single parent, qualifies as head of household, and has one dependent. Let's further assume that her deductions will consist of the standard deduction and two personal exemptions (one for herself and one for her child. The math for her withholding allowances would look like this (all figures below are for the 2012 tax year):

• Standard deduction: 8,700
• Personal exemptions: 2 x 3,800 = 7,600
• Total tax deduction: 8,700 + 7,600 = 16,300
• Deductions divided by personal exemption amount: 16,300 / 3,800 = 4.289

In this example, Mary would claim Single and four withholding allowances on her W-4 Form. (It's advisable to round down the ratio to avoid having too little tax withheld from your paycheck.) In other words, Mary would check the Single box on line 3 of the Form W-4 and would write "4" on line 5 of the Form W-4 where it asks for "Total number of allowances you are claiming."

See How Your New Withholding Allowances Will Impact Your Taxes

I go one step further when I adjust tax withholding. I take the new withholding allowances and plug it into a payroll calculator. Be sure to have your recent paystub handy so you can use your actual income amounts. Use these figures to see what your new paycheck might look like.

Next, extrapolate those numbers for the rest of the year (plus the withholding you already have year to date) to see what your total withholding will be for the entire year. Then compare your total withholding to your tax projection. If the withholding is too high or too low, go back to the payroll calculator to fiddle with the withholding allowances. Try Single instead of Married, or try changing the withholding allowances by one point at a time. (For example if you used Single-4 the first time, try a new calculation with Single-3.) Re-extrapolate the annual numbers and compare.

Repeat this process until you find the withholding level that will be just right for you. I try to get the withholding to produce a refund in the range of $500 to $1,000, figuring that gives my clients enough room so that any changes in income or deductions will not result in owing very much.

I find it's best to keep keep track of all of this math on a spreadsheet. This makes it easier to build alternate scenarios and projections. A spreadsheet also makes it easier to analyze the impact of changing your tax withholding mid-year (which is when most people make these sorts of changes).

You can do the same projections with your state taxes as well.