Increase (or Decrease) Your Tax Refund!

In a previous post, we talked about why it is that some people – even those with identical incomes – can have wildly differing refunds.  The person in the cubicle next to you, who makes the same salary, is always crowing about his $8,000 refund and you’re barely getting anything back at all.

What gives?

As we discussed earlier, a host of life situations can have an effect on your income tax refund.  Putting money into an IRA can significantly decrease your tax liability – while taking money out of an IRA can significantly increase it.  One person might have big capital gains in the stock market and another person might have capital losses that are just as big.

But one of the fundamental things that effects your income tax refund is the level of withholding on your paycheck.  It’s really the baseline that determines your refund, yet many people know little or nothing at all about how it works.

That is until today, because I’m going to explain it.

You’re welcome.

All right.  Back when you were first hired at your job – however long ago that may have been – you filled out a IRS Form W-4, which looks something like this.  The Form W-4 was part of that stack of papers you had to fill out on your first day, and so most people don’t remember it.  

What this form does is determine the number of exemptions that you’re going to claim for the purpose of payroll withholding.  And I emphasize that this is just for the purpose of payroll withholding and doesn’t necessarily reflect how many exemptions you’re going to claim on your actual tax return.  But more on that later.

The worksheet is pretty self-explanatory.  You enter a “One” on the worksheet for every situation that applies to you.  One for yourself.  One if you’re Married and the sole bread-winner in your family.  One for each dependent.   One for this.  One for that. 

Based on the W-4 Worksheet, if you were filling this out as Ward Cleaver – those of you under the age of thirty can ask your parents about that reference – your total would come to Five.  If June Cleaver had a job outside the home (like that would ever happen) and the Cleaver’s were paying for tax-deductible after-school care for the boys, the number would rise to Six.  If the Beaver ran off to join the circus and was no longer a dependent, the number would drop to Four.

So what do these numbers mean?  When the folks down in payroll are determining how much federal tax to withhold from your paycheck, they use a table provided by the IRS to every payroll department in the country.  Based on the number of exemptions you claimed on the Form W-4 and the amount of your paycheck, this table determines how much to withhold.

For example, if you made $500 per week and had just two exemptions (you were single with no kids), the payroll department would withhold $40 in federal income tax.  If you were Ward Cleaver and had five exemptions and $500 per week, the withholding would be only $11.  At seven exemptions, there would be no withholding at all.

So as you can see, the number of exemptions that you claim on the W-4 makes a huge difference in how much is withheld from your paycheck every week, and that effects how big your refund might be at the end of the year.  The larger the number of exemptions, the less the payroll department will withhold, and the smaller your refund will be.

So if it seems like you wind of writing a check to the IRS every April 15^th because you still owe taxes, a very simple solution would be to decrease the number of exemptions that you’re claiming; this will increase the amount that’s being withheld throughout the year, and that should take care of any shortfall.

By the same token, if you’re ending up with a whopping huge refund every year and are tired of giving the federal government a zero-percent loan (remember that a refund is your money), then you might want to increase the number of exemptions, which will decrease how much is being withheld.  You’ll have a smaller refund at the end of the year, but more money in your pocket on payday.

Increasing and decreasing the number of exemptions on the Form W-4 is often a perplexing concept, because taxpayers feel that the have to be withheld based on their actual number of dependents claimed on their taxes.  That’s simply not true. 

In fact, the instructions for the Form W-4 (which rank right up there with those airplane safety guidelines in the seatback pocket in terms of “Documents That Nobody Ever Reads”) includes instructions on how to increase your exemptions because you have large itemized deductions.  It would not be far-fetched for our friend Ward Cleaver to have 10 exemptions on his W-4.

If you haven’t done it for a while, and especially if your refund is larger or smaller than you’d like it to be, I would urge you to go fill out the Form W-4 and see what number turns up.  If it’s different from what they have down in the payroll department, you can change it.  Just sign the form and hand it over.  It’s that simple.

As always, if you have any specific questions, you can find me at jeffrey.ritchie@yahoo.com or follow me on Twitter at http://twitter.com/#!/MilwaukeeTaxPro