Tax Trap

Changes to the federal withholding formula could mean unpleasant surprises when it comes time to file income tax returns.

Most people who have earned a paycheck probably have discovered that the federal income tax withholding formula can be complicated. But changes to withholding stemming from the 2009 American Recovery and Reinvestment Act are causing even more head-scratching than usual this year, both inside and outside the federal workforce.

"When the tables first came out, there was a flurry of questions," said Michael O'Toole, senior director of publications and government relations at the American Payroll Association. "They were asking if this was a misprint. Why are there extra brackets?"

The changes caused some workers to see more money in their paychecks, and others less. But Internal Revenue Service officials stressed that although the withholding formula might be different, tax levels are not, and those who are having less withheld might end up owing some of the money back at the end of the year. They urged workers and retirees to make sure they're aware of how much is being withheld, so they aren't caught off-guard by a tax bill come April.

Aside from spending billions of dollars in the hope of rejuvenating the economy, the Recovery Act included the Make Work Pay annual tax credit -- worth $400 for single filers and $800 for married couples -- and a $250 tax credit for retirees. The Make Work Pay credit begins to phase out once individuals earn more than $75,000 annually and couples earn more than $150,000.

Because lawmakers wanted the credits to have an immediate effect, the measure also adjusted the withholding tables so taxpayers would have more money in their paychecks rather than receiving the extra cash in a lump sum.

The confusion stems partly from the fact the law was not in effect for all of 2009. The act wasn't passed until February and the changes didn't take effect until March; the withholding tables were calculated so the $400 or $800 credit was spread across nine months in 2009. This year the IRS changed the tables to spread that payment across the full year, which translates to a slight increase in the amount of money withheld in each paycheck.

For some people, however, that increase could be offset by other modifications to the withholding formula. To account for complex situations such as filers who work more than one job and the reduced credit for people over the income threshold, the IRS expanded withholding brackets from seven to nine and fine-tuned them, according to O'Toole.

Depending on how much you earn and whether you're a full-time worker or a retiree earning an annuity, the new withholding tables can affect you differently. For instance, while many are seeing an overall increase in withholding, the National Active and Retired Federal Employees Association issued a statement to its members after receiving inquiries from federal retirees who experienced a decrease.

O'Toole echoed the IRS' warning that due to the changes, some taxpayers might get hit with an unexpected tax bill this April, or in April of 2011, if they are not careful.

"People are going to have to pay attention, because they have to reconcile this credit when they file their tax return," he said.

More information about the changes due to the tax credits is available at the IRS' Web site.