You lend someone $1,000. To get repaid almost a year later, the borrower forces you to fill out a complicated form. Then he pays you back at his leisure--usually a month or two after that. He won't pay you any interest on the money, either.
Sound like a bad deal? Somebody must like it because millions of people accept this deal each year by allowing their employers to withhold too much in federal taxes from their paychecks.
Proof positive is shown in tax refund statistics put out by the Internal Revenue Service. Last year, the average federal tax refund amounted to $931, the IRS says. That's an interest-free loan to Uncle Sam.
If these taxpayers had deposited that $931 in the bank instead, they could have easily earned $50 in interest and they would have had ready access to their funds. Had the money been invested in higher-risk, higher-rate securities, they may have been able to earn considerably more.
Nevertheless, millions of Americans pay too much tax during the year and wait until the following March or April to recover their funds. Why?
Some are just careless, accountants say. These individuals have simply neglected to adjust their withholding as their families grew or as they took on deductible investments such as home mortgages.
Others look at withholding too much as a sort of forced savings plan. They are afraid they'll fritter away the money if they have access to it all year, so they'd prefer to have the government hang on to it.
Whatever the reason, making a large interest-free loan to the government--or to anyone else, for that matter--doesn't make good financial sense.
To avoid this, simply fill out a one-page form called a W-4 that is usually supplied by your employer or the IRS.
The top part of the form is a simple work sheet that asks how many dependents you have. Each dependent gets a tax exemption, and families with only one wage earner get an extra exemption. The backside is reserved for those needing to calculate the value of their itemized deductions.
The bottom part of the form is the certificate that you fill out to advise your company's payroll division of the number of exemptions you need, and it will calculate the amount of tax to be deducted from your check.
If you have no itemized deductions, you need only to fill in the front page, sign the form and give the bottom half to your employer.
But if you own a home, give money to charity or have deductible medical or business expenses, fill out the work sheet on the back. That will allow you to claim more exemptions and significantly lower the tax payments deducted from your paycheck.
As a general rule, accountants say it is better to have too little tax taken out of your check rather than too much. But there are some caveats.
The IRS can assess financial penalties if you don't pay enough tax through withholding or quarterly estimated payments. The reason is that the government doesn't want to lend you money interest free all year.
This doesn't mean that you're in trouble any time you owe tax at the end of the year. You will only be assessed penalties if you pay less than 100% of the previous year's tax liability or less than 90% of the current year's tax.
When should you revise your W-4?
If you are getting large tax refunds year after year, you are definitely withholding too much from your check. But if you have a one-time event that skewed your refund in a single year--loss of a job, investment losses or some other big non-recurring deduction--you may not need to adjust your withholding.
You should also adjust your withholding when you marry, have children, buy a house or have any other significant lifestyle change that can affect your tax rate.
If you are approaching year's end and realize that you may have significantly underpaid your taxes, you might also consider making an adjustment to increase the withholding. Before doing this, carefully estimate your tax liability.
Then, if the tax owed is much larger than the amount already paid in, you can have your payroll department withhold an extra sum from each check. This does not require you to adjust the number of exemptions claimed on the W-4. A separate line on the form asks for any "additional amount" you want deducted from your pay. You just fill in the appropriate dollar figure.
There is no limit to how frequently you can adjust withholding, so feel free to ask for and resubmit new W-4 forms any time it makes sense to do so.