photo © 2006 Ray Tsang | more info (via: Wylio)
For those of us interested in optimizing our personal finance, the income that the IRS takes out of our paychecks and holds hostage until we do our taxes in the next year creates a palpable feeling of pain. The idea that the government is taking the money I earn and is now generating interest income on it when it should be in my pocket is very frustrating. So, what can you or I do about it?
Well, not a whole lot it seems if you work for someone other than yourself.
One thing you can do is go through the somewhat arduous process that is the IRS Tax Withholding Calculator. Just remember you only have to do this calculation rarely so go ahead and suck it up and do it now, get it right, and move on to other methods of maximizing your finances.
Another option I recently read on the Get Rich Slowly forums (Thanks stannius!) if you do not expect major changes in your income from the previous year is:
1. Take the “Total Tax” from your previous year form 1040
2. Divide by number of paychecks (in my case, 26), rounding up to the nearest multiple of $5
3. File a W-4 with 99 allowances and the result of step 2 in the “extra dollar withholding” field.
I asked stannius whether the 99 allowances creates a red flag and this was his response:
“The IRS doesn’t actually care what you write down for allowances. I don’t think they ever see the information (W-4’s are for your employer, not the IRS).
What they do care about is how much you have withheld, relative to how much you owe. To avoid getting hit with a penalty, you have to have withheld the lesser of
1) Your current year tax liability minus $1000
2) 90% of your current year’s tax liability
3) 100% of your prior year’s tax liability (110% if your AGI was over a certain amount.)”
Doing this should place your withholding at the bare minimum and put you very close to break even with the IRS at year end. Thus, the federal government does not get to hold very much if any of your money hostage for months while you could be gaining interest on it. Unfortunately, my income is not quite stable enough to allow me to test this method, but it sounds like a very solid approach. I don’t know stannius or his background, but again it seems reasonable.
If you are self-employed, you should be paying quarterly taxes. If you’re not, you could be subject to penalties, but the reality is you can probably get away with settling up near the end of the year.
If you know of better data on how to minimize your withholdings or have tried the 99 allowances method, please comment!