Individuals who receive sizable tax refunds are usually pleasantly surprised by the amount of the refund. However, the government generally pays no interest on tax refunds. Tax filers can adjust the amount of tax withheld from their earnings by submitting an updated IRS Form W-4 to their employer.
An excessive level of income tax withholding has an effect on your cash flow throughout the year. The mismatch between withheld tax and actual tax is often due to a common misconception concerning Form W-4. Many tax filers assume that the number of withholding allowances calculated on Form W-4 should be the same as the number of persons claimed on their tax return.
Form W-4 withholding allowances
The IRS publishes several withholding tables that prescribe the amount of income tax that should be withheld from the earnings of an employee. The withholding requirement is dependent on the filing status of the employee and how often the employee is paid. The amount of withholding is also dependent on the number of withholding allowances calculated by the employee.
Additional withholding allowances
Form W-4 is designed to account for certain tax credits that reduce the amount of income tax otherwise payable. If you expect to claim the child tax credit, you may be eligible to add one or more withholding allowances to your Form W-4. An additional withholding allowance may also be available if you pay for childcare so that you can work.
Many employees rush through the completion of Form W-4 without calculating the effect of itemized deductions. If you expect to reduce your income tax by itemizing deductions, you may be able to add additional withholding allowances on your Form W-4. As a result, your tax withholding should be more in alignment with the actual tax reported on your tax return.
Positive effect on cash flow
Instead of a large refund, a more accurate Form W-4 is likely to result in a smaller refund or even a small balance due. Even so, the increased cash flow throughout the year presents an opportunity to earn additional interest on accumulated savings.There is generally not a penalty associated with a balance due if the final amount paid is less than $1,000.
The instructions for Form W-4 advise to complete a new Form W-4 each year or whenever your tax status changes. Contact a financial planning company like Family Financial Partners for more information on the effect of taxes on financial planning.