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.
