Overpayment of tax
While you’re working during the year, you have income tax withheld from your regular paychecks based on the number of withholding allowances you claimed at the start of the year. However, you may have overestimated the amount of tax you needed to have withheld this year. If you overwithheld and are counting on a big refund after April 15, you’re giving Uncle Sam the free use of your money.
Strategy: Adjust your withholding allowances on Form W-4. For instance, you might be entitled to claim an extra allowance for a dependent you’re supporting or you may have extra deductions or credits this year. There’s no reason why you should wait to receive more of your own money from the IRS in the form of a tax refund.
Note that you may be entitled to a Making Working Pay credit in 2009 equal to the lesser of 6.2% of earned income or $800 ($400 for single filers). The credit may be recouped through reduced withholding, but it phases out for high-income taxpayers.
Underpayment of tax
If you don’t pay enough tax during the year through quarterly installments or income tax withholding, the IRS may impose an estimated tax penalty for the underpayment. However, no penalty will be assessed if payments for 2009 equal at least 90% of your current tax liability or 100% of the prior year’s tax liability (110% if your AGI for the prior year exceeded $150,000).
Strategy: Adjust the withholding on your W-4 to fall within one of these safe harbors.
Once you clear the Social Security tax withholding maximum ($106,800 for 2009), allocate part or all of the savings into extra income tax withholding. This reduces the impact on your take-home pay.
The new economic stimulus law creates an additional safe harbor for 2009. If your AGI is less than $500,000 and more than 50% of the previous year’s income was derived from small business activities, you can base 2009 estimated tax payments on 90% of last year’s tax liability. For this purpose, a “small business” is one with an average of 500 employees or fewer.