For the next several months, U.S. taxpayers will begin filing their 2012 tax return, and that means many will be getting a tax refund.  In his article titled A Tax Refund Isn’t Always Something To Feel Guilty About, Associated Press personal finance writer Dave Carpenter states, “About 75 percent of individual taxpayers get a refund every year and the average amount is about $3,000.”  Some taxpayers like the idea of a tax refund because they see it as a simple, forced way to save, often treating it as “found” money they use to pay off debt, go on vacation, or fund some other financial goal.  Others, like me, see it as an unnecessary way of giving the IRS an interest-free loan.  Regardless of which camp you fall into, you may be able to control the size of your tax refund by adjusting the number of allowances you claim on your W-4.

Just so we are all clear, Form W-4 is the tax form W-2 wage earners complete when they are first hired.  On this form, you declare a filing status and a certain number of allowances.  Your payroll department uses this information and guidance from the IRS to determine how much federal income tax to withhold from each paycheck.

There is no required number of allowances, but in general, the more allowances you claim, the less tax you have withheld, and vice versa.  If you withhold too much, you get a tax refund; if you withhold too little, you owe the IRS money, which may include a penalty.  If you like the idea of getting a tax refund, the trick is to make sure you have more tax withheld than you owe.  If you don’t like the idea of a refund, the trick is to have enough tax withheld so that you either get back or owe just a little bit.

How do I determine the right number of allowances?

To determine the right number of allowances so that you withhold close to what you owe, you must look at your expected tax liability, and compare that to your projected withholding amount.  To make it easy, the IRS has created a withholding calculator. However, the calculator has been temporarily unavailable.  You can wait for the calculator to come back online, or you can use the same process the calculator uses to figure out the right number of allowances on your own.  Here’s how.

Step One: Estimate your total tax for 2013

If your household taxable income is less than $400,000 and not a whole lot changed from last year to this year, then you can use the results of your 2012 tax return as a basis for your estimate.  If, however, things changed from last year, these are the steps to estimating your 2013 total tax:

  • Start with an estimate of your 2013 gross taxable income.
  • Then subtract any contributions you expect to make to pretax accounts such as a traditional 401(k) or flexible spending account.
  • Next, subtract any above-the-line deductions you expect for things like contributions to a health savings account, moving expenses, alimony paid, deductible contributions to a traditional IRA, student loan interest, or tuition and fees.  This will get you to your adjusted gross income (AGI).
  • Next, subtract your deductions.  If you plan to itemize your deductions in 2013, you can use the 2012 Schedule A to estimate the size of your deduction.  Otherwise, the 2013 standard deduction for married taxpayers filing jointly is $12,200, for head of household filers it’s $8,950, and for single taxpayers and married taxpayers filing separately it’s $6,100.
  • Next, subtract your exemptions.  Each exemption is worth $3,900 in 2013.  This will get you to your taxable income.
  • Next, calculate the tax on this taxable income by looking up the amount in a tax table or by using the 2013 tax brackets.
  • Finally, subtract any tax credits you expect to claim, including the Earned Income Credit.  This will get you to an ESTIMATED total tax.

It is important to understand that this is just a simple, high-level overview of how you can estimate your total tax for 2013.  It does not consider all variables, including AMT, so you should review Form 1040 to fill in any items that may have been overlooked.

Step Two: Calculate the amount of federal tax you are currently on track to withhold

You will need a copy of your most recent paycheck stub to complete this step:

  • Start by looking at the amount of tax withheld year to date.
  • Then look at the amount withheld from your most recent paycheck.
  • Multiply the amount withheld from your most recent paycheck by the number of paychecks remaining in the year, and add this amount to the amount withheld year to date.  This will tell you how much you are on track to withhold for the year.

This works well if your income is steady throughout the year, but if you have irregular income, receive a periodic bonus, or have a change of income during the year, you may need to go through this exercise again.

Step Three: Adjust your withholding allowances

Based on your estimated total tax and the amount you are on track to withhold for the year, if you are projected to withhold a lot more than you owe, you may want to increase your allowances in order to withhold less per paycheck.  Conversely, if you are not on track to withhold enough, you should decrease your allowances, or even have additional tax withheld, so that you have enough withheld by the end of the year.  Because this is not an exact science, you may have to repeat steps two and three several times until you get your allowances right where you want them to be.

An example of this process

Let’s look at an example of how this might work for a married couple with two children under 17, household income of $100,000 a year, and taking a standard deduction.

Step One:

Gross income                                                                   $100,000

less pretax contributions                                                 – $5,000

less above-the-line deductions                                        – $2,000

less standard or itemized deduction                              – $12,200

        less exemptions (4 x $3,900)                                  -$15,600

Taxable income                                                                   $65,200

Tax (from tax tables)                                                         $8,888

        less child tax credits (2 x $1,000)                        – $2,000

Estimated total tax                                                      $6,888

Step Two:

Tax withheld year to date                                               $1,236

Tax withheld per paycheck                                                $412

Number of paychecks remaining                                           21

Withholding from remaining paychecks                       $8,652

Projected total withholding                                            $9,888

Step Three:

Projected total withholding                                            $9,888

Estimated total tax                                                          $6,888

Amount over withheld                                                    $3,000

In this example, the taxpayer is expected to receive a $3,000 tax refund if they don’t make any adjustments to their W-4.  If the taxpayer would prefer a larger paycheck to a large tax refund, they should increase the number of allowances on their W-4 until they have enough tax withheld per paycheck to cover the total tax, but not so much that they get a large refund.  It may take several adjustments to get it just right.