Exactly what will I get after messing with my withholding?

November 8, 2006 2:35 PM

I've got a mortgage and withholding question.

I'm about to buy my first house; I know that paying mortgage interest will allow me to change my (and my wife's) tax withholding, but I'm uncertain about some of the nitty-gritty there. Specifically, how can I calculate what our take-home income will be after our withholding is changed to take advantage of the new tax situation?

(I assume this is one of those questions that's butt-simple, but totally impenetrable if you're ignorant like me. I've spent quite a while googling, but get nothing but withholding calculators, which only seem to give me part of the picture)

posted by COBRA! to work & money (9 comments total)

generally the best thing to do, if you can afford to, is forget about it and get a nice refund back at the end of the year.
its pretty complicated to figure out how much exactly it will be unless you know all your other deductions.
posted by alkupe at 3:28 PM on November 8, 2006

Why change your witholding? None of my business, but my sense is most people don't. To figure it out you'll need a mortgage calculator.

Plug and chug - what is your monthly payment, interest rate, loan length? Figure out how much interest you'll be paying in a year. How much does that reuce your tax burden by? Now change your witholding that amount. You'll need to adjust it every year as more goes to principal and less to interest.

If you can afford to (being over-witheld is like making a no-interest loan to the Government and many people would rather save/invest/spend the money and then pay the taxes later) the easiest thing to do is just get a refund. You can use it for fun stuff like new water heaters and windows.
posted by fixedgear at 4:48 PM on November 8, 2006

I don't know how to calculate your new taxes, but I wholeheartedly disagree with those who say you shouldn't bother to try. Making an interest-free loan to the government is just silly, especially given that interest rates are on the rise. I hope that someone can help you figure this out, but if MeFi fails, it may very well be worthwhile to pay for a quick visit to a CPA for some real advice on how best to minimize the amount of money you unnecessarily fork over to the government.
posted by decathecting at 5:59 PM on November 8, 2006

decathecting is right. I would add that not only is it wise to avoid getting a refund at the end of the year, it's even better if you can owe taxes, since you are getting an interest-free loan in a sense. You have to be careful to avoid penalties for underpayment, though.

A lot of people like getting refunds because it is a form of forced savings. But there are better ways to force yourself to save money, e.g., automatic monthly deposits to a savings account.

As to your specific question, why not just do your taxes using last year's forms and next year's expected income and deductions, then divide the amount of taxes owed by the number of pay periods you have each year to get an estimate of your per-paycheck tax liability?
posted by brain_drain at 6:46 PM on November 8, 2006

Well, it depends on a lot of missing information but I'll make a swag just so you can get a feel if it is worth changing your withholding.

Assume your loan is for $200,000 at 6.5%. You will be paying $13,000 per year in deductible interest. If you multiply that by your tax bracket, say 28%, that means you will get a $3640 reduction in taxes next year. If you divide that by 26 pay periods, that works out to about $140 per pay check.

But wait, this assumes that you are already taking itemized deductions on your income tax, that is, you already have at least $5000 of deductions if you are single or $10,000 if filing a joint return. Most likely if you haven't had a mortgage in the past, you weren't itemizing using a Schedule A form. As a non-itemizer you in the past had an automatic standard deduction of either $5000 or $10,000. It is only the amount of new deductions above that standard amount that will contribute to lower taxes since if you itemize, you lose the standard deduction.

So as far as additional deductions, instead of $13,000, if you are filing jointly, only $3,000 will be additional tax deduction beyond what you had last year with the standard deduction. Add to that any charitable deductions, etc. So assuming you have $2000 of other deductions, your taxable income will be reduced by only $5000. Again assuming a 28% bracket, that is a $1400 tax reduction or $54 per pay period.

If you don't change your withholding it is approximately as if you are loaning the government on average half of that $1400 amount for a year, that is, $700. If you did change your withholding and put the savings in a money market account at 5%, you would save about $35 in interest per year, hardly worth losing sleep over.

Unless your budget is really tight, you might just forget about it for the first year, see how much tax you get refunded and make adjustments for the next year.

Many people make the mistake of thinking that all of their mortgage interest contributes to lower taxes, but they forget that the standard deduction has been raised significantly in recent years and they give up that standard deduction if they itemize.
posted by JackFlash at 7:21 PM on November 8, 2006

This won't answer your question, but once you get some info you'll want to use the IRS withholding calculator.
posted by powpow at 7:31 PM on November 8, 2006

Get TaxCut or one of the other tax-prep software packages and create some what-if returns, playing with the numbers. You may have to look up all the relevant forms first, since you don't have any old ones to work from. As long as the rules haven't dramatically changed between '05 and '06 (I assume it's too soon for '06 prep software to be available and you'll be using '05 software) you should be able to explore the cause-and-effect between your withholding and your mortgage interest, and can make some decisions based on that.

That's pretty much what a financial adviser will do, though obviously they will have more experience with it.
posted by Lyn Never at 6:31 AM on November 9, 2006

Thanks for the info so far... I'm definitely inclined not to just sit and wait for next year's return, both for cashflow and general-principle reasons.

The idea of playing with TaxCut (or equivalent) makes sense, although I think even then I'd stuill be missing one part of the puzzle: exactly what happens to my take-home pay if I adjust my withholding (I haven't used tax software before-- up until now, the returns have been too simple to bother-- so maybe I'm underestimating the amount of information they give).

Would it be a collossaly bad idea for my wife and I just to each modify our withholding slightly (like, each adding an allowance) and see what happens?
posted by COBRA! at 9:10 AM on November 9, 2006

What will happen to your take home pay is that you'll have more money in your paycheck if you increase the witholding. If you and spouse are disciplined enough to bank or invest it, great. If you get it just right, you'll end up just exactly perfect - not owing the IRS and not getting a refund.

Don't forget the deduction you'll get for real estate taxes, too, something that no one has mentioned. TaxCut or Turbo Tax do 1040sand the related schedules - if you want to see what a change in witholding will do, see powpow's link.
posted by fixedgear at 12:29 PM on November 9, 2006