Helping Your Working Clients Increase Their Take-Home Pay.
Byline: Mike Patton
During the month of March, we've been discussing ways to advise clients in the area of taxation as part of ThinkAdvisor's 22 Days of Tax Planning: 2015 special coverage. Because taxes are a crucial part of wealth management, it's important to understand how we can reduce the tax bite or help clients manage their tax liability. In this post, we'll look at how we can advise clients who are still employed and have taxes withheld from their paycheck.
Please note that I will be using the terms client and employee interchangeably.
The Tax Refund & the W-4
IRS Form W-4 is completed by the employee, held by the employer and is used to determine the amount of federal income tax to be withheld from an employee's paycheck. Ideally, the amount of tax withheld will be equal to the employee's annual federal tax liability. Many times, however, too much or too little is withheld, creating a refund or a need to pay additional taxes when the return is filed.
In the case of a large refund, it's best to reduce the amount of tax withheld by adjusting the W-4. This allows the employee to retain more of their earnings rather than loan it to the IRS interest free.
Here's an example to clarify how this works.
Let's assume we have a single employee who is earning $5,000 per month and claiming one allowance (i.e., dependent) on his W-4. The following tables show a taxpayer's wages, allowances, federal tax withholdings and net income for 2015.
In Table A above, the total tax withheld is $768.18 per month or $9,218.16 annually. Let's assume the client's actual federal income tax liability is $7,000. He would receive a refund of $2,218.16 ($9,218.16 - $7,000). By increasing his W-4 allowances to three, he would reduce his federal tax withholdings to an amount which is closer to his actual tax liability.
To illustrate, let's look at TABLE B below.
First, in Table B, the amount of income subject to tax withholdings is reduced by $666.60 to $4,000.10 (line 5). Next, his net income is increased by $166.65 per pay period or $1999.80 per year (line7). Finally, the total federal income tax withheld is $601.53 per month or $7,218.36 per year (line 6) which is slightly above his actual income tax liability of $7,000.
Obviously, we're comparing withholdings for the current year to the federal tax liability of one year prior. Therefore, it's important to make sure there have been no significant changes which may cause his tax liability to spike prior to adjusting the W-4.
This is another example of how we can help a client improve their tax situation. It's better to increase net pay rather than let the IRS hold the money and refund it at tax time. If you have clients who are working and receiving a large refund, this is an excellent opportunity to add value by showing the client how he can increase his net pay.
Until next time, thanks for reading and have a great week!
NOTE: The amount per allowance and tax rates used in this blog can be found on pages 43 and 45 of IRS Publication 15 (Circular E) Employer's Tax Guide. To view the Guide, click here
View all the content in ThinkAdvisor's 22 Days of Tax Planning Advice: 2015.