Should You Adjust Your Tax Withholding?

Now that tax day has passed, chances are you're either waiting patiently for your 2011 tax refund to arrive, it's already been spent, or you just wrote the U.S. Treasury a check and are in budget-cutting mode.

It's difficult to calculate exactly how much you will owe in taxes unless your income and family situation are identical from year to year. But going more than a few hundred dollars above or below your final tax bill is not a good idea: A big refund basically means you've been giving the government an interest-free loan all year, while significantly underpaying means you may have to pay costly penalties and interest on the amount.

Your goal should be to receive little or no tax refund next year. Better to use that money throughout the year to pay down credit card balances or other debt, build emergency savings, beef up your retirement plan contributions or invest it where you can earn interest or dividends.

Unless you're self-employed, retired or had unexpected sources of income, the driving factor for how much tax you owe or have refunded is probably your W-4 form. That's one of the many forms you filled out your first day on the job and probably never thought about again.

To refresh your memory: IRS Form W-4 determines how much federal income tax is withheld from your paychecks. The more allowances you claim on the W-4, the less income tax is withheld each pay period. When you file your yearly tax return, the government basically settles accounts with you: If they took out too much during the year, you get a refund; not enough and you pay additional taxes with your final return.

• Experience a significant increase or decrease in income.
• Add a second job, start or stop working (including retirement).
• Have a child (including adoptions).
• Reduce or increase how many dependents you're claiming (children or adults).
• Get married or divorced.
• Buy or sell a house.
• File for bankruptcy.
• Increase or decrease income adjustments for IRA/401(k) deductions, student loan interest payments or alimony.
• Significantly change your itemized deductions or tax credits, including: charitable contributions, expenses for medical care, job search, dependent care and interest (including mortgage), child tax credit or earned income credit.

Common sources of income typically not subject to withholding include: self-employment income, interest earnings, dividends, capital gains, alimony, rent, IRA or 401(k) distributions, taxable inheritances, prizes and awards. Estimated tax rules are fairly complicated, so refer to IRS Publication 505 for details on how to determine whether you need to pay it or not.

Filling out a new W-4. Ask your HR department for a new copy of the form, or download this version from the IRS that lets you enter your information electronically and print out a copy. The form contains worksheets for calculating your personal withholding allowances and estimating deductions, credits and other income adjustments if you plan to itemize expenses this year.

Generally, you'll claim one allowance for yourself and one for each of your dependents. However, you can adjust the number to avoid having too much or too little tax withheld from your pay. For example, if you have numerous deductions that will lower your taxable income (several children, a sizeable mortgage, high medical expenses) you can claim additional allowances. Conversely, if you expect sizeable untaxed income, you can reduce your allowances.

If you need additional help with the calculations, IRS Publication 919 provides detailed instructions. Or use the online IRS Withholding Calculator or those found in most tax preparation software packages.

And finally, if you have a working spouse or more than one job, the IRS recommends that you calculate the total number of allowances you're entitled to claim on all jobs using worksheets from only one Form W-4. Your withholding usually will be most accurate when you claim all allowances on the Form W-4 for the highest-paying job and claim zero allowances on the others.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.