Wednesday, April 07, 2010

No Tax Refunds

Megan McArdle has a great post on why it’s important to *NOT* get a tax refund. Long and short: you’re giving the government an interest free loan. Don’t do it. If you really like the forced savings, you can do that on your own AND earn interest. Adjust your withholding on your W4 form so that you don’t give them the interest free loan. Unfortunately, she doesn’t address how to adjust your withholding so that you can control how much you pay in taxes. So I’m stepping in to tell you what I do.

I should mention that I am *NOT* a tax attorney, nor an accountant. I’m simply telling you what I do and what works for me. If you decide to use this, and it doesn’t work out, don’t come looking to me for answers. You’ve been warned.

So here’s the deal. You want to withhold enough to cover what you’ll likely owe in taxes, but not too much so that you don’t give too big of a loan to the government. My personal goal is a $100 refund. My real goal would be a $0 refund. But the problem is that if I estimate wrong, I underpay. And our lovely government, who doesn’t pay interest if you overpay, will charge you a penalty if you underpay. !@#$%*^ hypocrites!

But it turns out that it’s pretty easy to adjust my withholding to be pretty darn close to what I want. Here’s what I do:
  1. On last year’s tax return, I look for the amount I owed in total tax. For 2009 (the one I just filed) it this was line 44 on form 1040. I don't know if it's always line 44, but that's what it was this year.
  2. I will use that number as a guess as to how much I will owe next year. Let’s pretend that the number was $2000 and that I get 24 paychecks per year.
  3. Now, if I want to get a $100 refund, I need to pay $2000 (what I estimate I'll owe) + $100 (my intended refund). And I need to divide that into 24 paychecks. Which means that I need to pay $87.50 per paycheck.
Now I know that I want $87.50 withheld from my paycheck to reach my goal of a $100 refund. To set that up, I get a W4 form from my HR department. It’s got a whole bunch of instructions on it. I ignore them & go straight to the form part:
  1. Line 5 on the W4 asks how many allowances I am claiming. Using the instructions, most people get fewer than 10. With 4 kids, I end up with about 10 allowances. But I declare 30. Yes, really. By declaring that large of a number, it effectively puts my federal withholding to $0 per paycheck.
  2. Now, of course, I don’t want to underpay, so on Line 6 it asks me how much additional I’d like withheld. Since I’m already at $0, and I know from above that I want exactly $87.50 withheld, I put $88.00 on Line 6 (the feds like to round to the nearest dollar, and I don't want to guess if they'll round up or down). And that’s the exact amount that my HR department will withhold for Federal taxes each paycheck.
I then do the same thing for the state withholding form, using last year’s state tax paid. It works well.

My point: I give the government a teeny tiny interest fee loan. Sure, I don't get that big refund every year, but I get a bigger paycheck each pay period.