On part one I talked about how to minimize your taxes and maximize your deductions. On the second part of getting ready for next year, I am going to show you how to maximize your paycheck by minimizing your withholdings.
- First, figure out how much money you need to have withheld from your paycheck every month. This step will require a bit of work but the exercise is very worth it. By now you have probably received your last pay stub. With it, plus some additional information you can estimate your 2007 tax liability using this tax estimator (first link on the left side). I think they recently redesign this calculator. The couple of things I notice are missing are deductions for 401K contributions and also for student loan interest paid. If any of those two apply to you I will deduct them directly from your gross income when using this calculator. By now it is too late to make any adjustments to your paycheck if you owe or are owed a refund but it is very useful to know where you will stand come April 15th of next year.
- Once you have determined your estimated tax liability, adjust your paycheck to more closely match what you need to have withheld. For this I use the paycheck calculator found here. Basically what you need to do is the following: if your tax liability this year is $2600 and you estimate that next year your income won’t change drastically and your situation will remain mostly the same (i.e. you won’t be adding any dependents, or buying a house, get divorced or get married) then you can assume that your tax liability next year will be very similar to what it was this year. If you want to make sure you don’t end up owing at all then you can add $xx amount to this year’s tax liability and have that amount deducted from your paycheck. So, let’s say you decide that you would like to have $3000 deducted from your paycheck and you get paid every two weeks. You need to have $116 withheld from each paycheck for Federal Tax purposes. You need to play around with the number of federal allowances you can enter in the calculator until the amount being deducted from your paycheck is closer to what you need deducted. Once you have determined the number of allowances you should be claiming submit a new W-4 form to your payroll/HR office to make the changes.
- You can also use this paycheck calculator to estimate what your paycheck will be if you have had significant changes to what gets deducted for employee benefits. Maybe your health insurance premium has increased, or you have decided to increase your 401K contribution. Enter any of these changes in the voluntary deduction section.
This really is a work in progress, so you might need to revisit this calculation sometime mid-year. Even then, last minute changes can ultimately influence your calculation. Every year I engage in these calculations at the end of the year. Also, during the year I calculate our tax liability every few months. Yet, I am still looking at a sizable refund for next year (adding a dependent will do that). I, however, enjoy knowing where I stand in terms of our tax liability. I rather engage in this exercise a few times during the year than be surprised once a year with how much I may end up owing the IRS. If you have any questions about how to use any of these calculators please feel free to leave a comment and I will answer promptly.