Take Your Tax Refund During the Year

Tell Me That This Isn't You

A lot of people like to get a refund after filing their taxes. Some would rather get money back than pay money in. Some use the tax system as some sort of wacky savings program and use their refunds for vacations or other purposes. Some think they've stuck it to the government by forcing it to give money back to them.

Let's back up.

Withholding 101

When you get paid, taxes are withheld by your employer and sent to the government on your behalf. We're all painfully well aware of this little fact; it's what makes our gross pay different from our net pay. Each pay period's withholding amount is an installment payment on the taxes we'll owe at tax time.

At the end of the year, you prepare your taxes and come up with the amount of tax that you owe. At that point, you compare the tax you owe against the sum total of your withholding for the year. If your total withholding is less than the tax owed, you now need only pay the balance. If your total withholding is more than the tax owed, the government refunds the overpayment to you.

Just Say No to Refunds

There's no magic here, just math. Your withholding is supposed to come close to your actual tax. If it is more than your actual tax and you get a refund, you:

• Are not getting a reward; you're just getting your overpayment back.
• Are not sticking it to the government; you're just getting your overpayment back.
• Have lost the potential use of that overpayment, including any interest it could have earned.

Tax refunds, then, are not good, even though they seem to be good because you're receiving money. Tax refunds mean that you've overpaid, and who wants to overpay for anything? Tax refunds mean that you are allowing money to flow out of your Cash Flow Cup unnecessarily.

Keep More of Your Money Now

The smart move, then, is to adjust your withholding so that it comes as close as possible to the actual tax that you owe. If you do this, you can take your tax refund during the year in the form of increased net pay. Last year, the average tax refund was $2,379; that translates into an extra $200 per month!

So how do you change that withholding amount that is deducted from your pay? Where does that number come from? Actually, it comes from you; you told your employer how much to withhold.

Huh? When?

W4...W4...Nope, Doesn't Ring Any Bells

Do you remember that W4 form that your employer gave you when you started the job? The number of allowances entered on that form are the basis of calculating the amount withheld from your pay. Most people submit a W4 when they start a job, and never think about it ever again. But you can submit a W4 at any time; when you do so, your new withholding amount will appear in your next paycheck.

Ok, so you submit a new W4 to change your withholding, but how do you know how many allowances enter on your new W4?

Pay No Attention to that W4 Worksheet

You can download a copy of From W4 online and fill it out yourself using the included worksheet to come up with a number of allowances to claim. However, to say it is a really rough ballpark estimate is an understatement. (Say, maybe that's why so many people over withhold.) Years ago, this crummy worksheet was the only tool available to us, but nowadays there are a lot more options available for calculating your allowances, so don't even bother with that W4 worksheet.

What you need is a W4 calculator that will consider your (and if married, your spouse's) salary and withholding to date, the frequency that you are paid, how many pay periods remain in the year, and an estimate of the other income (interest, dividends, self-employment income, etc) that you'll receive for the rest of the year. Fortunately, there are a lot of tools available to you.

Tax Software

I use Turbo Tax, and it has a nifty tax planning feature that walks you through an interview process and spits out a W4 for you (and your spouse, if applicable), ready for you to sign and hand in to your HR department. It works very well, and if you're married and your spouse works, it even load balances the required withholding between your two paychecks so that neither one of you will be stuck with too large a withholding burden.

Although I don't use TaxCut, I'd guess that it has similar functionality.

Online Calculators

If you don't use tax software, don't fret; the internet is awash in free online W4 calculators. Here are a few that I found:

• IRS Withholding Calculator from the IRS itself
• Paycheck Withholding Calculator from Turbo Tax
• Hitting the Mark on Withholding from Kiplinger's
• Form W-4 Assistant from PayCheckCity.com

Note to Self

As you punch numbers into the W4 calculator, remember to differentiate between your taxable and non-taxable income. You may have one or more paycheck deductions that are pretax. Common examples of these are 401k contributions, health insurance premiums, and flexible spending plans. Your taxable income is your gross income minus these pretax deductions.

Some calculators take these items into account, and some don't. Pay careful attention and if necessary, subtract these from the salary values that you enter, or you'll inadvertently overestimate your taxable income.

Don't Forget Your State Withholding

If you live in a state with an income tax, you have state withholding to deal with as well. Unfortunately, you probably won't find an online state withholding calculator to assist you. Fortunately, state taxes are usually simpler than Federal taxes. It's a little more work, but the math is pretty simple.

Estimate Your State Tax

Start by getting out last year's state tax form. Use it as a template to estimate this year's state tax. State tax forms typically start out with your adjusted gross income (AGI) from your Federal taxes, so plug in the estimated AGI that you got from the Federal W4 calculator. Proceed using last year's entries as a guide and make reasonable estimates for this year's values. Do the math, and come up with this year's estimated state tax.

Calculate State Withholding

Next, size up your current withholding. Get out the year-to-date pay stubs for yourself (and your spouse, if married) and total the state withholding so far. Next, add the future state withholding for you (and your spouse, if married) by multiplying your withholding per pay period by the number of pay periods remaining.

Now compare your estimated withholding to your estimated state tax and you'll have the estimated deficit or overage.

Calculate New State Withholding

The next step is to calculate the new future state withholding per period that you need in order to match the estimated state tax.

For example, say you're on track to overshoot your estimated state tax and get a state tax refund. To have your state withholding for the year match your state tax estimate, the new withholding per period would be:

New withholding = ( State tax estimate - year-to-date withholding ) / remaining pay periods

Determine State Allowances

Now you need to determine the number of state withholding allowances that you need to claim in order to arrive at the calculated new withholding. There are a couple ways to go about this.

First, you should be able to find a publication on your state's department of revenue web site that explains how to calculate state withholding based on the number of allowances claimed. This publication would used by employers and payroll services to calculate paycheck withholding. In Illinois, for example, it is Booklet IL-700-T, Illinois Withholding Tax Tables.

Once you find the particular publication for your state, use it to verify your current state withholding based on your current allowances (if you don't know how many you currently claim, check your pay stub). Then, experiment with adjusting the allowances until you arrive at the new withholding amount.

Alternately you can save yourself some some calculating and take a more trial-and-error approach by using an online paycheck calculator to experiment with state allowances. A couple that I have looked at are:

• PaycheckCity Paycheck Calculator
• YourMoneyPage Financial Calculators

These calculators allow you to enter your paycheck info, and then play "what if" by making adjustments. Start by entering your paycheck info, and verify that the calculator's results match your current paycheck. Then, experiment with state allowances until you arrive at the new withholding amount.

For either method, you may find that you can't quite match the calculated target withholding; 2 allowances, for example, puts you under your target, but 1 allowance puts you over it. In this situation, you may decide that you're close enough, and be done with it. If you'd like to fine-tune your withholding, however, you can typically do so by specifying an additional amount to withhold per pay period.

Submit Your State Version of the W4

Finally, fill out and submit your state's version of the W4. For Illinois, it is the IL-W-4.

Things Change

After you estimate your taxes and you (and your spouse, if married) proudly submit a new W4s to your respective employers, you might think you're all set. You're not. Remember, the original "problem" of a getting a refund was because you submitted a W4 once and then forgot about it.

Things that alter your taxable income are probably going to occur during the year. For example:

• Raises
• Bonuses
• Job changes
• 401k contribution changes
• Home purchases
• Births

To keep your withholding on target as things change, plan on repeating the process and submitting new W4s (if needed) quarterly.

There's a term for this: it's called tax planning. And you thought that was only for bigwigs!

Caveats

Your tax planning, by nature, will deal with estimates. Estimates of your income, estimates of your itemized deductions, estimates of your property tax for the year, etc. Early in the year, your estimates may be rough, but if you repeat the process each quarter, your estimates will get more and more accurate.

You won't be able to get your withholding to exactly match next year's tax liability, but that's OK. Instead, your goal is to come close. On tax day you want to get a small refund or owe a small amount. That's much better than getting a huge refund or owing a lot.

The Cash Flow Cup

The Way of the Cup

You should think of your checking account as a paper cup. Cash from your job, employee reimbursals, flexible spending plan reimbursals, eBay sales, etc, pour into the top of the cup.

But the cup has a hole in the bottom. Money flows out the hole as you make payments for your mortgage or rent, auto loan, credit card purchases, utilities, eBay purchases, etc.

So cash pours into your cup, accumulates, and runs out the hole in the bottom. If cash pours into the cup faster than it runs out, the level of cash in your cup rises; this is good. If cash runs out the hole faster than it pours into it, the level of cash in your cup falls; this is bad.

Where is This Going?

You may think this is leading to the topic of reducing the size of the hole in the cup; cutting back on your spending to stem the flow of cash from your cup. That's definitely a good idea, but not the idea that I want to convey via the Cash Flow Cup

Instead, I am interested in the rate of flow into and out of the cup: you want cash to flow into the cup fast, and you want it to slowly dribble out of the cup.

Why? Your checking account earns interest. A small amount, it is true, but this idea applies to all your other accounts as well, such as your money market account, which earns a higher rate of interest than your checking account.

You should apply the Cash Flow Cup principle to all your accounts. The idea here is to maximize every opportunity to build your wealth. The more money in your account, the more interest it will earn. And interest begets interest, and that is good.

Speed the Flow into the Cup

For example, nowadays, direct paycheck deposit is very common, and some employers require you to use it. But a few years ago it was more common for employers to hand out paper checks that had to be taken to the bank. When direct deposit was introduced most people (myself included) signed up.

But, there were several die-hard types that insisted on receiving those paper checks and driving them to the bank. They didn't trust direct deposit, even though the deposits were fast and automatic, and helped speed the flow of cash into their cups.

Similarly, do you find that checks from insurance or employee reimbursals pile up on your desk? That money isn't earning interest until it gets into your cup, so deposit those checks right away and speed those funds into your cup!

Slow the Flow out of the Cup

Many people like to pay bills the instant they arrive. They don't like the nagging feeling of having a bill to pay, and they don't want to miss the due date. But you typically have 30 days or so before the bill is due; to pay a bill long before it is due unnecessarily increases the cash flow out of your cup. You want to hold onto that money as long as possible before letting it go, maximizing the amount of time that money is earning interest.

The solution is easy if you use Quicken or other personal finance software that supports electronic payments: pay that bill right away if you must, but schedule the payment date to be a few days before the due date (to allow time for the payment to arrive).

What if you don't use electronic bill payment? The solution is just as simple: again, pay that bill immediately if you must, but don't mail it immediately. Instead, put a Post-it note on the envelope that instructs you to mail the bill with enough lead time (say, 5 business days) to arrive by the due date: "Mail on Friday March 16". Now place that envelope on the shelf or table or in your briefcase, wherever you put outgoing mail. Review the pile of envelopes each day, and drop each into the mailbox on the appropriate day (remove the Post-it first!)

The Cup is Your Friend

Think about the Cash Flow Cup always as you go about your everyday finances. Get that cash in fast, and be stingy about letting go of it. Make your cup runneth over, rather than run dry.