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Each year, U.S. Taxpayers usually get one of two things from Uncle Sam: a bill or a check. According to the IRS, 75 percent of taxpayers receive an annual average refund just below $3,000, and you can bet the forecast is 75 percent smiles the day that check arrives. The irony is that check is how much you overpaid in estimated taxes for the year, or put another way, the IRS’s way of saying, “Thanks for the interest-free loan buddy!”
“We’ve found that many taxpayers adjust their withholdings based on advice from friends and family instead of from a CPA or financial professional,” says Brian Wendroff, Managing Partner for Wendroff & Associates. “Honestly, during my first real job in the Army, my mother advised me to claim zero exemptions so I could withhold as much as possible, so I got a big check at tax time. Needless to say, she’s no longer my accountant.”
However, withholding too little throughout the year will lead to a 2210 penalty. The key to optimizing your payments actually lies in your W-4 and last year’s return. Ideally, you want to claim an exemption number that will result in withholding as close to what you owe as possible. Referencing your most recent paystub, use this IRS withholding calculator to guide your adjustments. To avoid a 2210 underpayment penalty, you want to hit the number of allowances that satisfy the lesser of 100 % (or 110 percent if your income for the prior year exceeded $150,000, or $75,000 if the taxpayer’s filing status for the prior year was married filing separately) or 90% of your actual tax liability.
Since many factors can change your tax status throughout the year, it’s a good idea to review your exemptions twice a year, around April/May and November/December.
You should also complete a new W-4 if any of the following situations apply to you:
* You got a big refund last year
* You owed over $100 last year when you filed your tax return
* You got married or divorced
* You had a child
* You can no longer claim a dependent that you claimed last year
* You bought a home
* You received a large bonus this year
For self-employed individuals, if you see signs of earning more than the prior year, you want to pay 110 percent of the prior year’s tax liability, which qualifies you for Safe Harbor status and protects you from a 2210 penalty no matter how much you earn over last year. If you can see you will earn less, you want to shoot for 90 percent of last year’s tax liability. If your situation gets complicated, it’s best to consult with a CPA, who can save you from surprise payments and penalties at year end.
Although many people will say the forced-savings refund check is their windfall after a year of hard work, behavioral economists find that people generally treat windfalls less responsible than they do earned money. And technically your tax refund is not a windfall. Investing that money automatically throughout the year can help you avoid spending it on things you don’t really need (i.e. a new Snuggie) and save it for important things (i.e. a new Snuggie for your favorite CPA).