Nothing puts a damper on tax season like an unexpected tax bill. And if the amount is significant, you could owe underpayment penalties, too.
Assuming you’re an employee (as opposed to someone who is self-employed, which is an entirely different ballgame), you can avoid this unhappy fate next year by increasing the amount of federal income tax withheld from your paycheck. Conversely, if you received a large refund, you should seriously consider having less withheld from your paycheck. Why give the government an interest-free loan when you could give yourself a raise?
Revise Your W-4
Ask your employer for a new W-4, the form that controls the amount of tax withheld from your paycheck, or download one at www.irs.gov/pub/irs-pdf/fw4.pdf. To increase the amount withheld, decrease the number of allowances. If you want to have less withheld, add more allowances. In 2014, each allowance will basically tell your employer to ignore $3,950 of your salary when figuring how much to withhold.
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If you experienced a big life change in 2013 or expect one in 2014, you probably need to update this form. For example, if you get married and one spouse earns significantly more, you will likely enjoy a marriage bonus. But dual-income spouses who earn about the same amount could end up paying a marriage penalty—which could result in an unexpected tax bill if you fail to adjust your withholding. Same-sex couples who are legally married may also face a marriage penalty (see Year-End Moves to Trim Your Tax Bill).
Similarly, having a baby will likely lower your tax bill—and not just because you get to claim an additional dependent, says Jackie Perlman, a tax analyst with H&R Block’s Tax Institute. You’ll probably also be eligible for tax breaks, such as the child tax credit, that will further lower your tax bill.
If you’re freelancing or starting a business on the side, consider decreasing the number of allowances you claim. By increasing your withholding, you may be able to avoid the hassle of paying quarterly estimated taxes on the additional income. You’ll also dodge a big tax bill, along with underpayment penalties, when you file next year.
Because withholding is based on annual salary, if you leave the workforce for a few months, you’ll probably have too much withheld when you go back to work, says Bob Meighan, vice-president of TurboTax. Instead of waiting for a refund, adjust your allowances to account for the downtime.
Calculate Your Allowances
Your tax preparer or tax software program should be able to calculate your withholding. You can also find a worksheet on Form W-4. There’s a separate worksheet for two-earner couples that helps you figure out how many allowances each spouse should claim.
If you received a big refund this year and don’t expect big changes in your financial situation, try our Easy-to-Use Tax Withholding Calculator. Use information from your 2013 tax return to answer three questions, and we’ll estimate how many allowances you should claim.
And note that if you show a pattern of underwithholding, the IRS may tell your employer to limit the number of your allowances, Perlman says.