tax withholdingAt an IRS tax workshop several years ago, someone asked the speaker if the IRS has a problem with taxpayers who get large refunds. We attendees were surprised to learn that the IRS does look upon large refunds with suspicion.

Why?

According to a discussion I had with an IRS professional, a refund of $3,000 to $5,000 is the optimum target for fraudsters filing fake tax returns and claiming earned income credits or child tax credits. There are entire rings of fraudsters operating from homes, offices, and even prisons. Because of this, when you are owed a large refund, expect the IRS to hold it for an extra day or two while its Criminal Investigation Unit does a quickie investigation.

Have I persuaded you to adjust your withholding to reduce your refund yet?

Perhaps you’re not convinced. After all, if the money is out of your hands, you can’t spend it. And because putting that money in the bank won’t even yield half of one percent in interest over the year, you might as well feel like you’re hitting the jackpot at the end of each tax season when that refund check hits your bank account.

But it’s time to grow up and take control of your own funds. You can get the same effect by having your employer deposit your paycheck directly into your savings account. You can then set up a transfer to move the funds you need to live on into your checking account. That way, you won’t be touching the savings, but you—not the IRS—will have your money.

To change both your federal and state tax withholdings, use IRS Form W-4. Just remember to write the name of your state on top of the form when you hand it to your payroll department.

Adjusting your withholding

In order to adjust your withholding, you first need to fill in your allowances on line 5 of your W-4. The more allowances you claim, the less tax will be withheld.

To figure out what to put on line 6, which asks for the specific amount you want withheld from each check, find last year’s total tax and deduct the federal taxes you’ve already paid (found in the year-to-date amount on your paystub).

Then use the following formula, assuming your financial situation hasn’t changed:

Your 2011 IRS total tax: $8,000.
Federal taxes paid year-to-date: $3,000
Difference between year-to-date and 2011 total: $5,000
Number of pay periods left in the year after payroll processes your request: 15

Divide the amount you still owe based on the previous year’s total (in this case, $5,000) by the number of pay periods left in the year (15). This will give you the amount that should be withheld each pay period ($333.33). You may want to round up to give yourself a little cushion. Then follow the same process to adjust your state withholding.

By following this formula, you will pay as much as you normally owe for both the IRS and state.

Keep in mind that if you adjust your withholding without fully understanding how your financial situation has changed, you risk owing the IRS at the end of the year. Take stock of your finances before making any changes, and consider using a withholding calculator—the IRS has one and so do most tax software services.

Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. She is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com and tax courses you might enjoy athttp://www.cpelink.com/teamtaxmama.