With the 2009 tax season coming to an end, it’s a good time to update your IRS Form W-4 on file with your employer (or yourself, if you are an S corporation owner).  Form W-4 tells your employer who much to withhold from your paychecks for income taxes. 

For most of us who are paid wages (that is, we receive a W-2 at the end of the year), the goal should be to withold just enough to cover total income taxes for the year.  Withhold too much, and our net wages are lower than they need to be, and we make interest-free loans to the IRS (these “loans” are paid back through tax refunds).  Withhold too little, and we end up owing additional taxes when we file our returns.  I’ve recently seen both over-withholding and under-withholding. 

I saw many instances of over-withholding in my experience with Volunteer Income Tax Assistance (VITA) Program sponsored by the Legal Aid Society of the Orange County Bar Association.  Through the VITA Program, volunteers (myself included) prepare income tax returns for disadvantaged individuals.  I prepared returns for several folks with little in gross wages but relatively high amounts withheld for income taxes.  These folks were often happy to be getting large refunds, but I’m sure their tight budgets would have been helped by keeping more of their own wages through accurate income tax withholding.  Some of these folks even qualify for the Earned Income Credit (EIC) and could have received EIC advances in their paychecks.

On the other hand, my partner and I personally experienced under-withholding.  We pay ourselves regular wage payments, but because we are S corporation owners, we also include in our individual taxable income the net income of our firm.  The withholding from our wage payments did not cover our taxable income, including the firm’s net income.  For 2010, our accountant (Amy Chapman at LarsonAllen in Orlando, Florida) has suggested that we increase the withholding from our wages to cover the additional income we expect to have as S corporation owners.

Whether over-withholding or under-withholding, the answer is to provide your employer a new IRS Form W-4 changing the number of allowances you claim (increase allowances to withhold less, decrease allowance to withhold more).  You can also use Form W-4 to specify an additional amount that you want to be withheld.  Give the new Form W-4 to your employer, and you should see the withholding change reflected in your next paycheck (or maybe the following paycheck) and continuing until you provide a new Form W-4.

How do you know how many allowances to claim or how much additional amount to withhold?  The best place to find out is at the IRS’s Withholding Calculator.  The Withholding Calculator asks questions about your filing status, your dependents, your anticipated taxable income for the year, and your year-to-date withholdings to determine how much additional taxes should be withheld and how you should complete your new Form W-4 to achieve that level of withholding.