Stop ‘Lending’ Money to Uncle Sam: Raise Your Withholding Exemptions

Q. I make $145,000 a year and my spouse does not work. We have three children and a sizable mortgage. We’re receiving a combined federal and state tax refund of about $12,000 for 2000. I’m not thrilled about making no-interest loans of that size to the government. I’d really like to reduce my withholding, but I’ve repeatedly been told--always in ominous tones--that going above 10 exemptions means “you have to tell the IRS.” I’ve reached the point where my response is “So what?” At more than 10 exemptions, do we become prime targets for an audit? How can it be worse than enduring cash-flow problems all year long?

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A. You don’t say so, but it’s probably the folks in your payroll department giving you the “ominous tones” rather than any tax specialist you consulted. A tax pro would know that this is one of the few cases in which the IRS’ bark is much worse than its bite.

If you take more than a certain number of exemptions--the IRS won’t specify the threshold, but nine is the generally understood limit--you’ll get a letter from the IRS asking why. You simply need to respond with a letter outlining your situation, just as you did above. If you want, you can hire a tax pro to write the letter for you, but it’s really not necessary.

Some workplace payroll departments have confused this simple contact by the IRS with a full-fledged audit and try to scare people away from taking the appropriate withholding. But it’s ridiculous to give the government money you’re not required to--let alone an extra $1,000 a month.

If you need help in figuring the right amount of withholding, you can check with a tax expert or use one of the many withholding calculators available on the Internet. The IRS has one at https://www.irs.gov, or you can try Intuit’s at https://www.turbotax.com.

As for being a prime audit target: Your high income makes you a somewhat more likely candidate for IRS scrutiny than the average taxpayer. And although the IRS is barely auditing anyone these days, that’s expected to change now that the agency has finished with its reorganization. Still, as long as your deductions are legitimate, if you report all your income and you keep your paperwork in order, you shouldn’t need to sweat an IRS review.

Estate Tax Dilemma

Q. My wife and I are 62 and 59 and have a net worth of about $3 million, including our house and our retirement accounts. We generally agree on money matters, but we’re having a disagreement about whether we should buy a “second-to-die” life insurance policy to help our children pay the estate taxes. A $1-million policy would cost $20,000 to $40,000 a year. We would give the money to our children and have them pay for the policy, so the proceeds would be tax-free for them when we pass away. We currently give each child at least $10,000 a year, which might need to be stopped if we buy the life insurance. Should we buy the coverage?

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A. Given your relatively young ages and your net worth, many estate planning experts would suggest you hold off on buying life insurance while Congress decides what it’s going to do about estate tax reform.

Currently, only estates worth more than a certain exemption amount are subject to federal estate taxes. The exemption amount, which this year is $675,000, is scheduled to rise to $1 million by 2006.

There’s an exception for married couples: A spouse can inherit an unlimited amount without paying estate taxes. That’s known as the marital deduction.

Congress is talking about repealing the tax entirely or--perhaps more likely--modifying it in ways to make far fewer families subject to the tax. The exemption amount could be raised to $2 million or more. If that happened, you and your wife--with proper estate planning--could pass your entire estate to your heirs without tax.

There are some risks in waiting. If you and your wife die together or within a short time of each other, and Congress doesn’t reform the estate tax system before you go, then part of your estate could indeed be subject to estate taxes and your children probably would have to sell some of your investments to pay the bill.

Then again, there are many things you can do to reduce the size of any future estate tax bill. Your best bet is to get some advice from a qualified estate planning specialist--one who doesn’t sell insurance.

You can contact your local bar association for a referral to an attorney who is certified in estate planning.

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Liz Pulliam Weston is a personal finance writer for The Times and a graduate of the personal financial planning certificate program at UC Irvine. Questions can be sent to her at moneytalk@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012. She regrets that she cannot respond personally to queries. For past Money Talk questions and answers, visit The Times’ Web site at https://www.latimes.com/moneytalk.