How Change in Wage Tax Bite Will Work

American taxpayers are likely to have a touch more cash in their pockets starting next month, thanks to President Bush’s decision to modify federal withholding tables.

Government rules now allow the Internal Revenue Service to collect too much money through employer withholding. That means Americans get lower paychecks during the year and big refunds at year end. Last year, 80 million taxpayers paid in roughly $70 billion too much, resulting in an average refund of $900 per taxpayer.

The problem with getting refunds is the checks are slow to come and the government doesn’t pay interest on the money. In other words, if the government held $500 of your money for a year, you lost at least $25 in interest that would have accrued if you had your bank hang onto the money instead. So allowing over-withholding doesn’t make much sense.

However, Bush announced in his State of the Union address that he was changing IRS withholding tables to reduce the government’s monthly tax bite starting March 1. The result will be that Americans will take home a bit more money during the year and have slightly smaller refunds at year-end.

How will this change affect you? That depends on your income and how you’ve filled out employee withholding forms in the past.

If you are married and you and your spouse earn more than $90,200 annually, the change does not affect you. Likewise, if you are single and earn more than $53,200, you are not affected. The government is only changing the tables for middle- and low-income families.

On average, single workers who earn less than $47,450 annually will see a change amounting to about $6.50 per paycheck, if they’re paid twice monthly. Married couples who earn less than $78,700 will get roughly $13.25 more per check.

To illustrate, consider a couple with two children earning $36,400 per year. They’ve claimed two withholding allowances and they have no itemized deductions. The working spouse’s employer is now withholding $81.06 per week in federal taxes.

When this change goes through, the employer will reduce the federal withholding to $74.42 per week--a $6.64 weekly savings, according to the Treasury Department. Normally, at year end this couple would get a $1,035 refund. But once the change goes through, their refund will drop to $747 because they paid in $288 less during the year.

However, anyone who does not ordinarily get tax refunds needs to be wary. They could end up owing the IRS money if they don’t watch out.

For example, let’s say this same couple normally claimed five withholding allowances. Under the rules now, they would neither get a refund, nor owe tax at year end. However, if they do not alter their withholding this year, they’ll end up owing the government $288 at tax time.

Accountants believe that the bulk of Americans do get refunds, though. So problems with under-withholding are likely to be rare.

Additionally, they note that Bush’s plan does not solve the over-withholding problem altogether. According to the Treasury Department, Bush’s plan will put about $25 billion back into taxpayer’s hands during the year. The government will still owe taxpayers about $45 billion at year end, which amounts to more than $550 per taxpayer.

For most, the sensible course is to get all of your tax refund up-front by having your employer only withhold the amount you expect to owe in taxes.

If you have a relatively stable income, you can figure out how much you’ll owe by doing a tax projection, which is similar to filing out a federal tax form. The main differences between doing a projection and doing your taxes is you’re dealing with estimated amounts on the projection and you’re probably rounding off the numbers to avoid adding and subtracting pennies.

When you’re done you should have a close approximation of your federal tax liability for the year, which can allow you to have your employer withhold just the right amount. (Completing an accurate tax projection can also help you reduce your taxes because it gives you a better idea of your financial situation and your ability to use tax planning techniques.)

If you’ve used over-withholding in the past as a forced savings plan, you should still adjust your withholding to the proper amount. Instead of getting a lump sum from the government at year end, you can invest the extra cash you have each month in something that’s likely to generate a reasonable rate of return.