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When I was a young guy working for a tiny paycheck, I actually looked forward to tax season because I knew I would get a nice chunk of money back from the IRS. I wasn’t aware that the money I was getting back was not actually free money, but was essentially a 0% loan I gave to the government.

Today, I take a much different approach. My goal each year is to get exactly $0 (i.e. no money received and none paid) for my tax refund. This takes a little planning at the beginning of each year, but, in the end, it’s worth it.

For this example, I will assume my salary will be $70,000 paid weekly, and my taxable income will be $50,000. Here are the steps:

1. Estimate your taxable income

This step is a bit of a guess, because the IRS does not give out this year’s tax forms until the end of the year (i.e. tax year 2007’s tax forms won’t be released until approximately October of 2007). I use the previous year’s forms which you can search for at the IRS’s web site. Don’t try and take the quick way out by just looking at the tax tables. If you do, you’ll be leaving money on the table, because you will not take into account any deductions.

As I mentioned earlier, this example assumes my taxable income will be $50,000.

2. Calculate the income that doesn’t need to be taxed

In our example, the salary is $70,000 and the estimated taxable income is $50,000. Since employers tax the full income (assuming 0 allowances), they will withhold taxes on not only the $50,000 of actual taxable income but also the $20,000 difference. The taxes on the $20,000 is what you will receive in a lump sum at tax season if you do not increase your allowances.

Divide this amount by the number of paychecks you receive in a year - 52 for weekly, 24 for semi-monthly, etc - to prepare for the next step. In our example, we divide the $20,000 by 52 to get $384.62.

3. Calculate your maximum allowances

We can calculate this number with the help of the following table:

Simply divide the number calculated from the last step by the amount corresponding to your payment period. The resulting amount is the number of allowances that will cause you to owe nothing at the end of the year (and receive nothing). For our example, divide $384.62 by the amount in the “Weekly” row ($65.38) to get 6 (rounded).

That’s it! Now you can use the extra money to pay down your credit cards, other high interest debt, or, if you are lucky enough to be debt free, invest.

Warnings!

If you rely on the tax refund as a savings tool for paying off credit cards or other debt at the end of the year, you probably shouldn’t try to maximize your paycheck.

This method is an ESTIMATE. Please consult a CPA for an exact amount. You can be subject to penalties if you underpay taxes throughout the year by too much.

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