Did you receive a big refund check from last year’s taxes? If so, you’re not alone. Many of us deliberately pay extra taxes throughout the year so we can enjoy a nice bonus early the next year. Sometimes it’s insurance against having to come up with extra cash when you file your return. That’s a valid concern. But sometimes it’s just a form of enforced saving. Or perhaps you’ve simply never bothered to adjust your withholding. Those aren’t such good reasons. After all, when you over pay your taxes, you’re making an interest-free loan to the government.
Should you adjust your withholding? Reducing your withholding is as simple as filing a new Form W-4 with your employer. The form comes with a worksheet to figure out how many allowances you should claim. Don’t forget to allow for other taxable income besides wages, such as dividends or investment gains.
If you’re worried about underpaying tax, there are a couple of rules you should know. Generally, you’ll escape a penalty if you pay, through withholding or quarterly estimated payments, at least 100% of last year’s taxes (110% if your adjusted gross income is over $150,000), or if you pay at least 90% of what you owe for this year.
If you reduce withholding, here are some ideas on how to use your extra take-home pay:
• Contribute more to your employer’s 401(k) plan, especially if your company matches contributions. You’ll enjoy a double benefit because the extra contributions will reduce the tax on your wages as well as provide tax-deferred savings.
• Pay down balances you’re carrying on your credit cards. That’s equivalent to earning interest on your extra payments, often at double-digit rates.
• Put the money in a tax-favored Coverdell IRA or Section 529 plan for your child’s education.
David Compton is a Certified Public Accountant with offices in Meridian and Birmingham, Ala.