Most Americans pay the bulk of their annual tax bills via payroll withholding. Through this process, a percentage of your pay is taken out each pay period and sent to the Internal Revenue Service where it is credited toward your final tax bill.
Payroll withholding is something you want to get just right. Why?
If you have too little taken out, you'll owe money when you file your return. That's not good, obviously -- no one likes to write out a big check to Uncle Sam.
If too much is withheld, you'll get a refund, and that's not good either. What's wrong with getting a refund? That means you've given Uncle Sam free use of your tax money, which you could have made better use of yourself throughout the year.
The best course, tax experts say, is to adjust your withholding so your tax payments will match your actual tax liability. To Uncle Sam, you will be neither a borrower nor a lender.
To make the change, file a new W-4 with your employer. This will change the amount that comes out of your paycheck.
You should do this any time there's a major change in your life -- such as marriage, birth of a child or purchase of a home. Each of these circumstances can affect the amount of tax you'll eventually owe. The IRS offers an interactive withholding allowance calculator and a couple of work sheets on page two of the W-4 form to help you figure out just what changes you need to make to your withholding amount.
If you find the IRS language a bit dense, Bankrate explains it in "Understanding the W-4."
The Paycheck Effect
Those who usually write a big check to the IRS may have to deal with a slight cut in take-home pay so that it doesn't happen again. You can decrease the number of personal allowances on the W-4 form or simply ask that a set amount be taken from your paycheck each period.
To figure out how much, take the amount you paid to the IRS and divide it by the number of pay periods remaining in the current year. No one likes to see a paycheck shrink, but it will make next April much less painful.
If you regularly get a big refund, increase the number of personal allowances. Once you get the correct amount taken out and have a bit more cash each paycheck, don't automatically spend it. Because you're no longer a customer of the Unofficial Bank of the IRS, open an account -- savings, money market or certificate of deposit -- at an institution where your money will earn you, not the federal government, interest.