How to Adjust Tax Withholdings

by Ryan Yates

I’m sure most people have heard the terms Tax Withholdings and W-4s. After receiving my tax refund I decided to see how I could adjust my taxes in order to not receive a refund next year. First we need to get everyone on the same page and understand the differences between the terms listed above.

Tax Withholdings:

The federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year.
As a wage earner, you pay federal income tax by having it withheld from your pay during the year. This is your “withholding.” Your withholding is based on the number of allowances you claim when you file Form W-4, Employee’s Withholding Allowance Certificate, with your employer. (IRS Publication 919)

W-4:

W-4 is a tax form used by the United States Internal Revenue Service. The form is used by employers to determine the correct amount of tax withholding to deduct from employees’ wages. Ideally, this amount will exactly equal the annual tax due on the 1040 series related to employment compensation, though in reality, many times it is off by a substantial amount. (Wikipedia)

In order to figure out the correct withholdings you will need to gather some information.

  • Print this form out from the IRS, How do I adjust my tax withholding
  • Have a copy of your tax return handy for reference
  • Have a copy of your Schedule-A Itemized Deductions sheet if you plan to itemize

Withholdings using the Standard Deduction
If you use the standard deduction, adjusting the withholdings may not help much. If you are having a child or are caring for a relative, then you can adjust the withholding by 1 for each case. Adjusting more will leave you open to the possiblity of having to pay next April. Use the IRS Withholding Calculator to enter your information to see how it can benefit you.

Withholdings using Itemized Deductions
If you pay mortgage interest, state taxes, property taxes, medical expenses in excess of 7.5% of your income, or have charitable contributions then you probably receive a much larger tax refund. These are all deductions that reduce the amount of taxes you pay resulting in overpaying the govenment throughout the year. In an ideal world the government would take out the correct amount of taxes, leaving you with only a small amount pay back or receive. Having a small amount at the end of the year means you can have extra money each paycheck to help with debt reduction, bills, and even investing. Having the government hold onto money I can use to get out of debt doesn’t sit well with me.

There are a few tools to use to help you understand the correct amount of withholding to claim on your W-4 forms. The first is the IRS Withholding Calculator. The tool requires you to enter a bunch of information. Below is a snapshot of one of the screens.

You will also need some information about itemized deductions. If your pay will remain about the same, use your Schedule-A form from your tax return to enter these values. Example, if you pay state taxes and property taxes add these up and enter the value. Enter the mortgage interest from last year since it will likely be very close to this year. After all the information is entered. The IRS calculator will tell you how many withholdings you should claim.

I was very surprised by the amount of withholdings I should claim for 2010. I have been claiming 4 which has resulted in a large tax refund. After using the calculator, I’m now changing my withholdings to 8. Now that you know how many withholdings to claim how do you figure how much extra money you’ll be getting in each paycheck. Use this calculator provided by Yahoo – How Will Payroll Adjustments Affect My Take-Home Pay? The calculator is very simple to use. Plug in the required values and it will show you the amount of extra money you’ll be getting in your paycheck. It works great and I will be getting almost $300 extra per month. That money will be applied to my debt and help to really make that snowball roll faster down the hill.

The Back Check
I love the ablity to use online calculators and such to make life easier, but whenever taxes are involve I get a little worried. To back check the calculator the IRS has a worksheet that you can manually use to figure out the correct withholdings Worksheet. I used the form and was able to reach the same results. Now that I’ve performed the actions required for me to sleep well at night, it’s time to adjust the withholdings.

The W-4
The IRS has a W-4 form avaliable online for download: Form W-4 (2010). Most employers use their own form so you need to contact your HR person to locate the correct form to use. Once you have the correct form, just fill it out and send it in. Your employer will make the changes and you’ll see some extra money in 1 to 2 pay cycles.

In the past I’ve read many different articles about adjusting tax withholdings. I followed one of them two years ago. The advice was to add an exemption for yourself, my spouse, my children, and my mortgage. That was 4 at the time. I was still getting a large tax return, so that’s why I dug into the issue. Personal finance and taxes are completely dependant on YOUR situation. Rules of thumb are great, but rarely apply to each person. I hope that you’ll use this information to figure out how to adjust your withholdings. Please seek the advice of a professional if you have questions. Remember that I’m just a pizza delivery guy working his but off to get out of debt. This is just another way to increase the traction required to get out of debt. If you love getting a huge tax return, don’t change a thing. Good luck everyone.

Here are a couple more tax related links to check out – 2010 Tax Brackets and Marginal Tax Rate
and what you should know about the 2010 Estate Tax

{ 17 comments… read them below or add one }

JoeTaxpayer February 25, 2010 at

Nicely done, my friend, and tagged for my weekly roundup. Important for people to understand that big refunds mean Uncle Sam is earning money that you can use to pay debt or earn interest.

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Jeffrey Kosola February 25, 2010 at

It’s a very easy way to use your own money. I was quite surprised at just how easy the process was to complete. I hadn’t done it in a couple of years, now I will look at it every year. The extra three hundo will go along way for me 🙂

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RainyDaySaver February 25, 2010 at

Excellent explanation. Now that we have a mortgage, we may adjust our withholding. Because I also do freelance gigs on the side (1099), it’s difficult to gauge just how to adjust our exemptions, because that income varies widely. I used to be a fan of getting the big refund until I realized I was just letting the government hang on to money that we could use for debt repayment. Alternately, getting that tax refund may work for those folks who have trouble saving their money — as long as they use that chunk of cash to pay down debt.
.-= RainyDaySaver´s last blog ..Ever Feel Like You Can’t Get Ahead? =-.

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Jeffrey Kosola February 25, 2010 at

Agreed, the tax refund is a forced savings account for some people. I would rather adjust my withholdings and set up an account to automatically deduct an amount from my paycheck into a savings account.

The money can go a long way for many people. Imagine if somebody reads their “new” credit card statements and can be out of debt quicker only if they can pay a little more than the minimum payment. That money could come from their withholdings and they could pay the card down that much faster.

Good luck working on the exemptions, and that mortgage is going to help your taxes a lot.

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LeanLifeCoach February 25, 2010 at

Jeff, let me challenge you a little further…

Now that you will have some extra income and you know exactly how much that is, what are you going to do to make sure it is used in the most efficient manner? Will you take the automated approach and have it diverted to a debt electronically, build the e-fund or manually allocate it?
.-= LeanLifeCoach´s last blog ..Dealing With Debt Collection – =-.

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Jeffrey Kosola February 26, 2010 at

Thanks for the challenge LeanLifeCoach,

I currently use one of my ING savings accounts to hold my “debt payment” money. At the end of the month, the money is paid to the debt I’m currently snowballing. The lender will not take multiple payments throughout the month so I sit on the money until I can make the large payment. The “new” money will be set up to automatically pulled from my check into my debt account. I just have to wait and see how long my employer takes to update their system.

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Stay at Home Mom CFO February 26, 2010 at

I used the IRS withholding calculator too and while I felt it was accurate I wanted to back-check as well. I’m not 100% sure all the recent credits (ie Making Work Pay) will still be in effect come 2010 tax season so I took them out of my calculations when doing my own manual check. Just in case!
.-= Stay at Home Mom CFO´s last blog ..Weekly Round-Up – Snowed In (AGAIN!) Edition =-.

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Financial Samurai February 27, 2010 at

Good stuff man. B/c I don’t bother to do any of these calculations (lazy, donno how to do so well) I just leave it as 0, and pray for the best.

It’s kinda a good thing this year, since despite 0 withholdings, I still owe some money. Shitake.
.-= Financial Samurai´s last blog ..The Curse Of Making Too Much Money And Not Pursuing Your Dreams =-.

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Evolution Of Wealth February 28, 2010 at

Great explanation and directions. I can’t understand why someone would give an interest free loan to the government. If you use it as forced savings, isn’t that just a cope out?
.-= Evolution Of Wealth´s last blog ..Pricing Your Disability Insurance =-.

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Evan February 28, 2010 at

While I get the whole argument, not giving a tax free loan to the gov’t, but what is worse than a bill from the IRS, when you might or might not have the cash to pay?

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Jeffrey Kosola February 28, 2010 at

I understand your point. When you go through the caluations you round down the withholdings, leaving you with a very good chance of getting a small refund. I need the money now to continue blasting the debt. I can handle sending the gov a little later.

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Steve March 3, 2010 at

I run the IRS’s withholding calculator multiple times per year. One wrinkle in my withholding situation is that I want to have all the taxes withheld from my paycheck, and none from my wife’s paycheck at her main job. The other wrinkle is that my wife has multiple side jobs, some of which pay her as an employee (W-2) and some of which pay her as an independent contractor (1099) – and all of which we can only estimate the income for.

I guess given all that, I shouldn’t be surprised that I never quite get the withholding right.

I don’t mind owing money as long as I don’t get hit by a penalty. Once I was supposed to have a penalty, but I checked the box to have the IRS calculate it for me and they never responded. It was a small penalty – I was only over the “safe harbor” by $20 or $30.

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Jeffrey Kosola March 3, 2010 at

Wow Steve, that’s great. Sounds like you are an expert with the IRS 😉 Having the mix of the W-2 and the 1099’s sounds like a headache. I’ve only had to work with W-2s and it works great so far. We’ll see what happens this year.

Thanks for your comment today,

Take-Care, Jeff

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Daniel March 8, 2010 at

I wrote about this back in October when I adjusted my withholdings and changed to 10 allowances (!), and I STILL am getting $585 back in federal taxes and $283 back in state taxes. I tried to stop it, and I guess I came fairly close (If I hadn’t changed anything, I would have gotten back about $3,000 combined), but I hate giving the government an interest free loan!
.-= Daniel´s last blog ..Are Employers Making Crazy Assumptions? =-.

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Jeffrey Kosola March 8, 2010 at

@Daniel, at least you won’t be paying Uncle Sam. I’m all for getting the money to use when I want to. I think you still get money back because of rounding the withholdings down. For me the calculator showed 8.7 as my number but says to round down. I should be getting my newly calculated pay check soon 🙂

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PT January 5, 2011 at

Definitely and interesting rule of thumb you used to reach 4. I’m currently researching this topic and I’d never heard of that one. Excellent write up. You really showed what it takes to get your W-4 to where it needs to be. Most people never take the time to do this properly. It’s really a shame that is has to be this difficult.

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Jeffrey Kosola January 6, 2011 at

Hey Phil, I just ran my numbers through for the year (2010) and after changing my withholdings to 8 last year I still came out a couple grand ahead. I did have some OT that was taxed higher that helped, but having the extra money each pay check really fired up my debt snowball. Thanks for the comment. By the way, having paid off my 2nd mortgage last year is causing me run my numbers again because I won’t be able to claim the interest anymore.

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