Arizona’s New Withholding

Arizona has done it again.  Currently, anyone who is being paid in Arizona must select from several percentages on the A-4.  Arizona withholding is based on a percentage of federal withholding.  The percentage you pick will be multiplied times the federal withholding number on your paycheck to arrive at Arizona withholding.  If you selected 24.5%, and your federal withholding was $112, then your Arizona withholding would be .245×112 or $27.44.

This created a problem with all the federal withholding changes that have happened over the last 10 years.  Each time there was a withholding decrease, Arizona’s revenue decreased as well.  The Making Work Pay Credit last year decreased checks for everyone and was the last straw in the problem.  Arizona’s legislature had to increase the percentages on this form each time the federal government decreased withholding  just to keep withholding even. Finally, last year, the legislature directed the AZ Department of Revenue to develop a new withholding system to be put into place by July 1, 2010.

There are other glaring problems with this method.  Arizona’s tax rates are based on a formula.  By requiring employees to pick a flat percentage, they are forced to determine a marginal (or average) tax rate for their tax situation.  This can change based on events in a person’s life like marriage, divorce, new children, home purchase, a second job or a spouse begins working that didn’t before.  Any of these events change the marginal rate.  Most people never adjust their A-4.  This obviously causes frequent confusion.

Another problem is that many people simply have no federal tax liability.  With no federal withholding, there was no way to have any Arizona withholding and inevitably, these individuals would end up paying extra every year at tax time.

Yet another problem is those that move into the state mid-year.  As a Tax Preparing CPA, I found it very difficult to advise my clients when they move in mid- year which percentage to pick.  The problem still exists in the second year (first full year of residence) since they have no history to draw from in selecting their percentage.

So…..Arizona’s new method was recently announced and here is the form.  All employees must complete a new one of these by July 1, 2010.  Guess what? They solved none of the above mentioned problems and even made some new problems.  Now, the percentage you select is percent of gross pay.  This decouples the state from federal withholding changes but still does not give employees who are new a clue to which rate to select.  Now instead of new employees only being confused, any person working in the state gets to be confused and not just for half a year, but for next year as well.  There is still no basis in the actual tax rates with these percentages.

Instead of providing some rates that anyone can pick, there are still three lines for employees to select based on income level.  This should have been removed.  If you have very low tax liability but a higher than $15,000 income, you cannot select the lowest rate.  On the back of the new form, there is a worksheet provided.  Notice in line 10 of the worksheet that there is no provision in the instructions for selecting anything other than line 1 (front side) percentages.  What if the calculation result is lower than the percentages on the form?

Employees are not able to determine their “target” withholding without digging into last year’s tax return or contacting their tax preparer.  Again, changes in taxable life events make last year’s number irrelevant.  What are you supposed to choose? This value is difficult for those without a tax background to understand.

Supposedly, payroll “experts” were used to help develop this form.  Unfortunately, they chose to tweak the existing system enough to only make things more confusing.   I hope that the state will make some wholesale changes to this form to more closely match what other states are doing and what the Arizona tax system actually looks like.  It’s not bad to use withholding allowances and marital status.  We are forced to use that on the tax form.   Let’s get this right next time.

401(k) Early Withdrawal

Q. I borrowed $15,000 from my 401(k) in Feb, 09. In May, 09, I was laid off from my job. My only options for the loan were to pay it in full (not going to happen) or default. They would NOT allow me to continue making payments and would not transfer the loan to my new employer!  Anyway, can you tell me how to calculate the penalty that I will be charged when i file my taxes for 2009?

A. Generally, the fees charged for early withdrawal amount to a 10% penalty.  Sometimes the vendor of the company’s 401(k) plan will take the 10% penalty from the proceeds when someone cashes out a plan.  However, in your situation, there was no way to know this would eventually be considered a cash out.  Because the contribution to the plan is pre-tax for federal purposes, you will pay regular income tax on the withdrawal as well.  This means the calculation of total income on your tax return for 2009 will include the loan balance that was forgiven.  Your taxable income will be higher than it would have been without this dollar amount.  How much higher is to be calculated between you and your accountant or tax preparer. You can run a calculation for estimated annual liability using Publication 919 from the IRS. Beware!!! This process is like completing a simulated tax return.  If you miss one number in your calculation, the whole thing could be wrong.  This of course does not help you find your tax liability number.

If you find after working through Publication 919 that you will be short on your tax liability payments, you can adjust your withholding with your new employer for the remaining periods in the year.  This is a good idea to ensure that you don’t have any underpayment penalties at tax time.  Also, you can estimate what your check would look like using any changes you might make to your withholding allowances using the free Paycheck Calculator at PaycheckCity.com.

Math Problems on the W4?

Q. First, please explain the notes on line G of the W4 that talks about what to put on the form for children using different income levels. Secondly, I claimed 8 allowances last year and there were no taxes taken out of my check.  This year when I complete the form it shows 9 or 10 (bought a house).  How does that work, if 8 had already put me at no taxes?

A. See form W-4 before reading this explanation.  Most of the credits enacted in the last few years are phased out for higher income earners.  Line G of the Form W-4 deals with child tax credits and these credits are no different. The credit begins to phase out when Adjusted Gross Income (AGI) reaches the following levels:

• Married Filing Joint: $110,000
• Single and Head of Household Filers: $75,000
• Married Filing Separately: $55,000

To accommodate the reduction in the credit, you need to reduce the number of allowances you claim towards that credit. This makes your withholding increase but is correct because you will receive less credit and owe more in tax.  Therefore your withholding needs to increase anyway.  Those under the income threshold will still be able to claim extra allowances since they receive the full credit.

Regarding your second question, the number of allowances you claim should not be based on the number it takes to get your withholding to zero for federal purposes.  In your case, you bought a house.  If the mortgage qualifies, that means you now get to claim property taxes and mortgage interest on the itemized deduction form of the 1040.  Normally, this reduces taxable income and thus you get to claim more allowances.   If you think about it, now you have extra deductions available to absorb any salary increases that may happen in the future.  Talk you to tax preparer or CPA if you have specific questions regarding your situation.

Enough Allowances, It’s So Confusing

Q. I know you get a lot of questions about this, but I think I may have not been allowing myself the number of allowances that I am qualified to receive. I am 33, single, have 2 homes in a separate state, both are rented. Should I be able to claim an allowance of 3, for tax and interest and depreciation for those homes?

A. The question of the “right” number of allowances to claim is a tough one.  For most people, it simply involves completing the Form W-4 as correctly as possible using any the necessary worksheets on the back side of the form.  For others, because of some extra factors that are not handled in the W-4, finding that number is an interesting problem.  In your case, the two homes in other states that are rentals are most likely considered a passive investment meaning you probably cannot fully deduct any losses that occur.  The best way for you to determine how many allowances to claim is to sit down with your tax advisor or CPA and go through last year’s tax situation.

On a side note, make sure you have mentioned the 2 rental homes.  By maintaining homes in other states from your resident state, you likely will need to complete a tax form for those states even if you have no actual tax liability.  Often, sales tax is required on the rental price of your homes along with the normal property taxes.  Make sure you check with the taxing jurisdictions where your homes are located.  You don’t want to be caught by surprise with sales taxes.

Exempt status part-time

Q. Is it illegal to claim exempt status on my W-4 for a couple of paychecks?

A. To get the answer to your question, we need to examine the statements on the W-4 relating to the exempt status.  Exempt means you will have no federal withholding on your paycheck.  It does not affect Social Security and Medicare withholding.  To be exempt, the form requires that you verify the following two conditions:

• Last year I had a right to a refund of all federal income tax withheld bec ause I had no tax liability and
• This year I expect a refund of all federal income tax withheld because I expect to have no tax liability.

If you are not able to say yes to both statements, look carefully at the statements at the bottom of the form, “Under penalties of perjury, I declare that I have examined this certificate and to the best of my knowledge and belief, it is true, correct, and complete.”  If you are willing to accept the risk detailed in the “jurat” statement at the bottom of the form, then it is fine to do this.  But let’s think about this carefully.  Are you only going to meet the qualifications for exempt for two weeks?  If you have knowledge that you will not be eligible for it for the rest of the year, then you should not do it.

If you meet with your tax advisor or CPA, they will be able to help you claim the correct amount of allowances for your situation to keep a constant withholding number for the entire year.  If you are a commission-only employee and your commissions vary widely, then it is still best to complete your W-4 claiming the number of allowances to which you are actually entitled.  Using Publication 919 later in the year, you can get a good idea if your withholding will be too much or not which will give you an idea if you should adjust your W-4 for the remainder of the year.

Withholding…My Way!

Q.  As a payroll person, I often see highly-compensated employees come to my office with advice from their accountant.   “If you withhold exactly this amount every period, you won’t owe or need to be refunded very much on income taxes.”  Because the accountant may take into account things that would not be known to a payroll system, they think this will be more accurate.  I thought withholding was based on allowances and filing status.

A. The answer to this dilemma for all payroll departments is clear in Publication 15.  Here it is: “The amount of any federal income tax withholding must be based on marital status and withholding allowances. Your employees may not base their withholding amounts on a fixed dollar amount or percentage. However, an employee may specify a dollar amount to be withheld in addition to the amount of withholding based on filing status and withholding allowances claimed on Form W-4.”  What does that mean?  It does NOT say if you are an executive or highly compensated that the accountant can choose my withholding method.  It DOES say to base withholding on the Form W-4 values, filing status and number of allowances.

Here is an example.  Let’s say I make $110,000 per year, am married with two kids under 12 and have a substantial mortgage and some charitable giving.  My accountant says I should have $19,000 in withholding for the year.  Since I am paid semi-monthly, that means 19000/24 or about $791 per check in federal withholding right?  Wrong.  To properly calculate this, visit the free Paycheck Calculator at PaycheckCity.com.  Plugging in the numbers, and playing around with the allowance value and filing status, I see that if I claim single with 2 allowances, I will get around $19,000 in federal withholding for the year.   Thus, I will complete my W-4 with those values.  It’s really a handy tool and it solves the dilemma presented above.

On a side note, just because you are married, you are not required to have taxes withheld using the married filing status.  The object is to get your payments (withholding) and liability (tax return) to match using the tools provided on the Form W-4.

Decrease withholding on paycheck

Q. I would like to ask how I can decrease the withholdings from each paycheck…I am married, salaried about 52K yearly; HR explained to me that I needed to increase the number of dependents (?!) I bought a house, I will therefore deduct the mortgage interest and the taxes. I live in Florida. Thanks for your help!

A. I get so many W-4 questions that it’s almost impossible to know where to start. Your HR department Read more »

A New W-4 Every Year?

Q. My employer says I have to complete a new W-4 every year. Is this true? How often do I have to do this? It’s always the same.

A. I’m amazed at how many questions come in regarding the Form W-4. This deceivingly simple Read more »

Frequent W-4 Changes

Q. My paycheck is never the same because I’m in sales. I’m always adjusting my W-4 to get the withholding right. Now my payroll department is telling me I have to wait a month before my changes are input. Is this legal?

A. As I say all the time in this blog, the W-4 is the employee’s best tax planning tool. If you get the right amount of withholding set, you will have neither a large refund or a large extra payment when you file your taxes. Unfortunately, that is the ideal situation that most people never see.

Per IRS Publication 15, “If an employee gives you a Form W-4 that Read more »

Too Much Withholding = Free Loan to the Government

Q. I had way too much withholding last year and got a huge refund when filing my tax return. How do I change that?

A. This blog is coming from the floor of the Exhibit Hall at the American Payroll Association 2008 Congress in Austin, TX. With almost 2000 payroll folks surrounding me, I get to see the other side of your question as well. Payroll folks sometimes can’t understand why the regular employees don’t Read more »