Withholding for Employees: End of Year Planning

11/1/2011 | Written by: Karen Reed, EA

If you are an employee and usually receive a large tax refund each year, it’s likely that you haven’t claimed enough withholding allowances on the Form W–4 you filled out at work. Having too much money withheld from your paychecks means that you are effectively giving the government an interest-free loan while missing out on a larger paycheck and the interest income you could be earning on your own money. If you find yourself in this situation, consider filing a new W–4 with your employer.

Ideally, you should try to claim the amount of allowances that will result in withholding that matches as closely as possible the amount you owe. Since many life situations can change your tax status during the year, it’s important to review your allowances annually to make sure that your withholding is close to your tax liability. A good time do this is in November, as this will give you enough time to make an adjustment on your W–4, if needed. If your withholding is too low, you can file a new W–4 with your employer and have an additional amount withheld from your paycheck on top of your regular withholding for the remaining two months of the year.

As long as your withholding is equal to at least 90% of your tax liability in the current year, or 100% of your prior year’s tax liability, you won’t be subject to a penalty for under withholding. The percentage goes up to 110% if your income is over $150,000, or $75,000 for married taxpayers filing separately. Also, you generally won’t be subject to a penalty if you owe less than $1,000.

The Form W–4 has a worksheet that will assist you in claiming the correct number of allowances. In 2011, each additional exemption that you claim on your tax return reduces your taxable income by $3,700. If you are in the 25% tax bracket, for example, adding an exemption will reduce your refund or increase the amount you owe by $925. If you work more than one job, or have just gotten married or divorced, had a child, or bought a new home, you may want to review and adjust the allowances you are claiming.