Tax-Rate Cut to Add a Little Extra to Some Paychecks

Middle- and upper-income taxpayers are likely to see a few extra dollars in their paychecks next month, thanks to lower tax withholding spurred by the big tax cut passed by Congress in May.

The Internal Revenue Service is distributing new withholding tables to employers that reflect the 1-percentage-point cut in tax rates that goes into effect July 1, the first of several rate cuts included in the Economic Growth and Tax Relief Reconciliation Act of 2001.

The government wants employers to implement these changes immediately. However, the exact date is up to employers, and some may not be able to move that quickly, according to a survey by the American Payroll Assn.

The withholding changes are not related to tax rebate checks that are going out next month--another result of the tax bill. Tax rebates ranging from $300 to $600 will be sent out as a partial refund for taxes already paid from January through June. The withholding changes, on the other hand, reflect lower tax rates going forward.

Although the rebate checks will go out to virtually everyone who paid tax last year, the withholding changes affect only people who are paying 28% or more of their marginal income in federal tax.

And don’t expect a windfall. Because the tax cut saves only $10 a year for every $1,000 earned over set income thresholds, the effect on each paycheck will be modest this year. In future years, as tax rates drop a bit more, the savings will be bigger.

“It’s a slow, gradual tax cut, but I guess that’s better than no tax cut at all,” said Philip J. Holthouse, partner with the Los Angeles tax law firm of Holthouse Carlin & Van Trigt.

How much of a difference will the withholding changes make?

If your gross income is $2,200 a month and you get paid every two weeks--by far the most common pay period--the amount withheld from your paycheck for federal income tax will drop by $1 to $3 per paycheck, depending on how many personal exemption credits you claim. Those earning $4,000 a month will see their take-home pay rise by $13 to $14 every two weeks.

These savings should show up automatically in your paycheck. But you may be due more.

That’s because your W-4 form--which tells your employer how much tax to withhold from your paycheck--doesn’t include enough information to indicate if you qualify for some of the more lucrative breaks in the new tax law.

If your withholding should be even lower than indicated by your W-4--you have young children who qualify for special tax breaks, for example--you have a decision to make: Do you want to get every penny of your tax break today by further reducing the amount withheld from your paycheck, or are you willing to wait until next spring to get the full effect of the tax cut in the form of a lower tax bill or bigger refund from the IRS?

If you want the break now, you will need to fill out a new W-4. But be careful, said Brenda Schafer, senior tax research coordinator at H&R; Block in Kansas City, Mo. If too little tax is taken out of each check, you could end up with a nasty surprise in April, when you could owe tax and penalties.

To be sure that doesn’t happen, you need to estimate your savings from the new tax bill carefully. The process is complicated enough that it’s advisable only for people whose cash flow is so tight that a few extra dollar per paycheck will make a significant difference in their lives.

To do the estimate, you first need to get a good idea of how much tax you’ll owe next year. The Web site of CCH Inc., a Riverwoods, Ill.-based publisher of tax information, at https://tax.cch.com/tax calc/ provides a simple work sheet where you can fill in your income, filing status and number of children under age 17. The calculator then will tell you roughly how much you’ll pay in federal income tax this year.

Compare that to the amount of tax that already has been withheld from your wages. (Employers often list “year-to-date” taxes paid through withholding on weekly or biweekly pay stubs. If yours doesn’t, you can ask, or simply add up the federal taxes you’ve paid from all the pay stubs you’ve received so far this year.)

Next, subtract the amount of the rebate you’ll receive: up to $300 if you’re single, $500 if you’re the head of a household, or $600 if you’re married and filing a joint return.

Look at the amount withheld for federal income taxes from the first paycheck you receive after your employer has implemented the new withholding tables. (The new tax law does not cut state income taxes.) Multiply that amount by the number of pay periods left in the year.

Add that to what you’ve already paid, and compare the result to what you expect to owe based on the CCH calculator.

If it’s still apparent that you will pay too much income tax through employee withholding, talk to your payroll department. Your company payroll representative can help you fill out a new W-4 form and reduce the automatic deductions, leaving you with more disposable income.

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Getting a Break

As part of the big tax cut Congress passed last month, federal income tax rates will fall over the next several years, with the first decrease effective July 1. Workers paying marginal rates of 28% or more will save about $10 for every $1,000 they earn each year.

The IRS has asked employers to pass on this savings by reducing the amount withheld from paychecks for tax purposes. Who will see boosted paychecks as a result?

* Singles earning more than $27,050

* Married couples earning more than $45,200

* Single parents earning more than $35,150

*

Here’s an example of how the new withholding limits will work:

* Annual income: $54,500

* Current biweekly withholding: $560.89

* Withholding after July 1: $545.89

* Increase in take-home pay: $15

Note: Example assumes a single person with one personal exemption credit. Withholding includes federal income taxes, Social Security and Medicare.

Source: Internal Revenue Service