Refund isn't found money; it's your money

Q: I've always enjoyed my tax refund and considered it found money.

I think I've seen the light, and I realize that the extra tax I've been paying all year long could have been directed toward my credit card debt. My interest rate on my debt is pretty low at 8.9 percent, but I didn't earn anything on my tax money.

I've been told that my refund will be delayed because of IRS form changes and a revised 1099 from a mutual fund I own.

My questions:

* How do I adjust my withholding so that I don't underpay or overpay this year?

* Does it make sense to owe taxes if I have the discipline to save money to pay what I owe?

A: Congratulations on "seeing the light." One of my best friends insists that it is a good idea to have more tax withheld throughout the year, then she goes on vacation with her refund. It drives me crazy, and we've just agreed not to discuss the topic and to remain friends.

Money from a tax refund hasn't earned any interest over the year. It doesn't make sense to let the government use your money when this money could have been directed toward debt payments or to a money market account earning about 3 percent.

Even directing the money into a savings account with a low rate of 0.5 percent would provide more after-tax money than letting the government use the money all year and give it back as a tax refund!

The goal concerning income taxes should be to pay enough throughout the year to avoid any underpayment penalties and have money set aside to pay any additional taxes owed once you have completed your tax preparation. This allows you, rather than Uncle Sam, to have control over the money.

Everyone should recalculate their withholding and estimated tax payments each year because tax laws and individual tax situations often change. If you are employed, request a new form W-4 from your employer. IRS Form W-4 determines how much federal income tax your employer will withhold.

You will want to claim more personal allowances if you anticipate a large refund for 2007 and your personal and financial situation is unchanged. If you are retired or self-employed, you will want to reduce your estimated tax payments.

If you have the discipline to save during the year to cover any taxes owed, by all means, do so. But be sure to pay enough tax to avoid the underpayment penalty.

There are several underpayment safe harbor rules that will allow you to avoid the underpayment penalty for 2008:

* If you have a predictable income, you can make estimated tax payments or have your employer withhold taxes from your wages equal to 90 percent of your expected tax for 2008.

* If your adjusted gross income is less than $150,000 -- or $75,000 if married filing separately -- you can avoid any underpayment penalty by paying 100 percent of the total tax shown on your 2007 return.

* If your adjusted gross income is more than those amounts, you must pay through withholding or estimate the smaller of 90 percent of your 2008 tax liability or 110 percent of the tax shown on your 2007 return to avoid an underpayment penalty.

One exception to the underpayment penalty applies if the total tax due after subtracting withholding or estimated payments is less than $1,000; other exceptions are calculated on IRS Form 2210.

If you don't feel comfortable determining the amount of withholding or estimated taxes on your own, meet with a tax professional.