Avoid under-withholding penalties
originally posted: 11/22/2006 reposted: 2/19/2011
Q: I received a large tax refund last year so I filed a changed W4 form with my employer to reduce the amount of taxes withheld each paycheck. My paycheck went up by $200 per week which is great but how can I be sure that I won’t owe a big tax bill at the end of the year?
A: The smartest way is to make a quick estimate of your taxes for 2005 and make sure that total withholding is at least the amount you paid last year. Calculating an estimate for the current year is usually not as difficult as you might expect and can be done simply by making a photocopy of your 2004 tax return and writing any significantly different expectations for 2005 in the margins on the first page of the retun. The impact of your expected change becomes obvious in the tax calculation section of the return. Alternately, online sources like Quicken.com provide a calculator for this purpose and the IRS provides an online worksheet. In most cases only modest changes need to be made to the estimated total tax due. OnlineAdviser can help with this if necessary and in most cases only takes a few minutes regardless of the method used.
Then take the resulting total federal income tax you expect to owe for 2005 and subtract the amount already withheld in the “year to date” column of your paycheck stub. The difference is the amount you should plan to have deducted from paychecks for the remainder of this year. Simply take this number (remaining estimated tax) and divide it by the number of paychecks you expect to for the rest of the year. This result is the ideal amount of federal income tax to have deducted from each paycheck. If there is a significant difference between the ideal amount and the actual amount being withheld, talk to a tax adviser or file another adjusted W4 form. There tax penalties for substantial under withholding of federal income taxes that can be avoided by using the mid-year tax planning procedure listed above.