If you fail to estimate your federal income tax withholding properly, it may cost you in a variety of ways. If you receive an income tax refund, it essentially means that you provided the IRS with an interest-free loan during the year. By comparison, if you owe taxes when you file your return, you may have to scramble for cash at tax time--and possibly owe interest and penalties to the IRS as well.

When determining the correct withholding amount for your salary or wages, your objective should be to have just enough taxes withheld to prevent you from incurring penalties when your tax return is due. (You may owe some money at the time you file your return, but it shouldn't be much.) You can accomplish this by reading and understanding IRS Publication 505 and 919, properly completing Form W-4 (and accompanying worksheets), and providing an updated Form W-4 to your employer when your circumstances change significantly.

Two factors determine the amount of income tax that your employer withholds from your regular pay: the amount you earn and the information you provide on Form W-4. This form asks you for three pieces of information:

• The number of withholding allowances you want to claim: You can claim up to the maximum number you're entitled to, claim less than you're entitled to, or claim zero.
  
• Whether you want taxes to be withheld at the single or married rate: The married status, which is associated with a lower withholding rate, should generally be selected only by those taxpayers who are married and file a joint return. Other people (including those who are married and file separately) should generally have taxes withheld at the higher, single rate.
  
• The additional amount (if any) you want withheld from your paycheck: This is optional; you can specify any additional amount of money you want withheld.

When both spouses work and have taxes withheld at the married rate, they sometimes end up with insufficient taxes withheld. If this happens to you, remember that you can always choose to withhold at the single rate. In addition, you can determine the proper withholding amount by completing Form W-4's two-earner/two-job worksheet.

To understand Form W-4, you must understand allowances. Think of allowances as cash in your pocket at the time that you receive your paycheck. The more allowances you claim, the less taxes are taken from your paycheck (and the more cash ends up in your pocket on payday). For example, you can maximize the amount withheld from your paycheck to ensure that you have enough tax withheld to cover your tax liability by claiming zero allowances. This will reduce the amount of cash you take home in your paycheck. The following factors determine your number of allowances:

• The number of personal and dependency exemptions that you claim on your federal income tax return
  
• The number of jobs that you work
  
• The deductions, adjustments to income, and credits that you expect to take during the year
  
• Your filing status
  
• Whether your spouse works

To claim the correct number of allowances, you should complete Form W-4's worksheets. These include a personal allowances worksheet, a deductions and adjustments worksheet, and a two-earner/two-job worksheet. IRS Publication 505 (Tax Withholding and Estimated Tax) explains these worksheets.

Federal law requires your employer to let you change your allowances at any time. You do this by submitting a new Form W-4 to your employer. Changes in your personal life, as well as changes in the tax law, may result in your having too little or too much tax withheld from your paycheck. If you get married, buy a home, have a baby, or experience any other major financial life change, consider re-evaluating your withholding. And in some cases, such as divorce, you may be required to submit a new Form W-4.

If you accurately complete all Form W-4 worksheets and don't have significant nonwage income (e.g., interest and dividends), it's likely that your employer will withhold an amount close to the tax you owe on your return. In the following cases, though, accurate completion of the Form W-4 worksheets alone won't guarantee that you'll have the correct amount of tax withheld:

• When you are married and both spouses work
  
• When you are working more than one job
  
• When you have significant nonwage income, such as interest, dividends, alimony, unemployment compensation, or self-employment income
  
• When you'll owe other taxes on your return, such as self-employment tax or household employment tax
  
• When your withholding is based on obsolete W-4 information for a substantial part of the year
  
• When your earnings are greater than $150,000 if you're single, or $200,000 if you're married

In these cases, IRS Publication 919 (How Do I Adjust My Tax Withholding?) can help you compare the total tax that you'll withhold for the year with the tax that you expect to owe on your return. It can also help you determine any additional amount you may need to withhold from each paycheck to avoid owing taxes when you file your return. Alternatively, it may help you identify if you're having too much tax withheld.

Selecting a filing status is one of the first decisions you'll make when you fill out your federal income tax return, so it's important to know the rules. And because you may have more than one option, you need to know the advantages and disadvantages of each. Making the right decision about your filing status can save money and prevent problems with the IRS down the road.

Your filing status is especially important because it determines, in part, the tax rate applied to your taxable income, the amount of your standard deduction, and the types of deductions and credits available. By choosing the right filing status, you can minimize your taxes.

The five filing statuses are single, married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child. There are six income tax brackets. Your tax rate depends on your filing status and the amount of your taxable income. For example, if you're single and your taxable income is more than $8,025 but not more than $32,550 (in 2008), it's taxed at 15 percent. If you're a head of household filer, though, your taxable income can climb to $43,650 and still be taxed at 15 percent. So, it's clear that some filing statuses are more beneficial than others.

Although you'll generally want to choose whichever filing status minimizes your taxes, other considerations (such as a pending divorce) may also come into play.

This one's pretty straightforward. And, depending on your circumstances, it may be your only option. Your filing status is determined as of the last day of the tax year (December 31). To use the single status, you must be unmarried or separated from your spouse by either divorce or a written separate maintenance decree on the last day of the year. Unfortunately, you jump into a higher tax bracket more quickly with the single status than with some of the other filing statuses.

You may file jointly if, on the last day of the tax year, you are:

• Married and living together as husband and wife
  
• Married and living apart, but not legally separated under a divorce decree or separate maintenance agreement, or
  
• Separated under an interlocutory (i.e., not final) decree of divorce

Also, you are considered married for the entire tax year for filing status purposes if your spouse died during the tax year.

When filing jointly, you and your spouse combine your income, exemptions, deductions, and credits. Filing jointly generally offers the most tax savings for married couples. For one thing, there are many credits that you can take if you file a joint return that you can't take if you file married filing separately. These include the child and dependent care credit, the adoption expense credit, the Hope credit, and the Lifetime Learning credit.

Still, this filing status is not always the most advantageous. If your spouse owes certain debts (including defaulted student loans and unpaid child support), the IRS may divert any refund due on your joint tax return to the appropriate agency. To get your share of the refund, you'll have to file an injured spouse claim and probably have to jump through hoops. You can avoid the hassle by filing a separate return.

You and your spouse can choose to file separately if you're married as of the last day of the tax year. Here, you'd report only your own income and claim only your own deductions and credits. Filing separately may be wise if you want to be responsible only for your own tax. With a joint return, by comparison, each spouse is jointly and individually liable for the full amount of the tax due. So, if your spouse skips town, you'd be left holding the tax bag unless you qualified as an innocent spouse.

Filing separately might also be the best tax move if one spouse has significant medical expenses or miscellaneous itemized deductions. Your ability to take these deductions is tied in to the level of your adjusted gross income (AGI). For example, medical expenses are deductible only if they exceed 7.5 percent of AGI. By filing separately, the AGI for each spouse is reduced. Keep in mind that if you and your spouse file separately and your spouse itemizes deductions, you'll have to do the same.

Remember, though, that you won't qualify for certain credits (such as the child and dependent care tax credit) and can't take certain deductions if you file separately. For example, you cannot deduct qualified education loan interest if you're married, unless you file a joint return.

Those who qualify for the head of household filing status get special tax treatment. Not only are the tax rates lower for head of household filers than for single filers and married filing separately filers, but the standard deduction is larger as well. However, you'll have to satisfy the following requirements:

• Generally, you should be unmarried at the end of the year (unless you live apart from your spouse and meet certain tests)
  
• You must maintain a household for your child, dependent parent, or other qualifying dependent relative
  
• The household must be your home and generally must also be the main home of a qualifying relative for more than half of the year
  
• You must provide more than half the cost of maintaining the household
  
• You must be a U.S. citizen or resident alien for the entire tax year

You may be able to select the qualifying widow(er) with dependent child filing status if your spouse died recently. This status allows you to use joint tax rates and offers the highest possible standard deduction, the one applicable to joint tax returns. To qualify, you must satisfy all of the following conditions:

• Your spouse died either last tax year or the tax year before that
  
• You qualified to file a joint return with your spouse for the year he or she died
  
• You have not remarried before the end of the tax year
  
• You have a qualifying dependent child
  
• You provide over half the cost of keeping up a home for yourself and your qualifying child

As you can see, choosing the correct filing status is not always easy. You might want to speak with a professional tax preparer or consult IRS Publication 17 for more information.

Even the most honest of taxpayers can be left trembling at the thought of an IRS audit. Let's face it--it's right up there with public speaking. To survive an audit, you've got to arm yourself with information. You should understand what the audit process is all about, why your return was audited, what your rights and responsibilities are, and how you can appeal the findings.

An IRS audit is an impartial review of your tax return to determine its accuracy--it's not an accusation of wrongdoing. However, you must demonstrate to the IRS that you reported all of your income and were entitled to any credits, deductions, and exemptions in question.

The IRS must complete an audit within three years of the time the tax return is filed, unless tax fraud or a substantial underreporting of income is involved.

Several factors can lead the IRS to single out your return for an audit. For instance, taxpayers who are self-employed, receive much of their income in tips, or run cash-intensive businesses face a greater likelihood of audits. The IRS also pays more attention to professionals such as doctors, lawyers, and accountants (who often run their own businesses and do their own bookkeeping). In addition, if your itemized deductions in several major categories--medical and dental expenses, taxes, charitable contributions, and miscellaneous--are greater than average, you'll have an increased chance of being audited. Other red flags may include:

• A return that is missing required schedules
  
• A return that is missing a required alternative minimum tax form
  
• A return signed by a preparer associated with problems in the past
  
• A return reporting income of at least $150,000

If you are to be audited, the IRS will inform you by letter. There are three types of audits:

• A correspondence audit: This is for minor mistakes and requires only that you mail certain information to the IRS. For example, maybe you forgot to attach a Schedule C to your income tax return. The matter will be closed if the IRS is satisfied with your paperwork.
  
• An office audit: Here, you'd typically bring your tax-related records to an IRS office for examination. For example, if you claimed an unusually high deduction for medical expenses, the IRS may want to see your medical bills and canceled checks, among other things.
  
• A field audit: Here, the auditor generally visits your home or business to verify the accuracy of your tax return. It may be possible for the auditor to visit the office of your representative, instead.

You have several rights when you're involved in an audit. These include:

• The right to an explanation of the audit process
  
• The right to representation by an attorney, CPA, or enrolled agent
  
• The right to claim additional deductions that you didn't originally claim on your tax return
  
• The right to request an opinion from the IRS's national office on specific technical issues that arise during the audit

Consider the following when you are audited:

• Request a postponement (whenever you need it) to gather your records and put them in order
  
• Be sure to read IRS Publication 1 (Taxpayers' Bill of Rights) before your audit
  
• Before your initial interview with the IRS agent, meet with your representative (if any) to discuss strategies and expected results
  
• Bring to the audit only the documents that are requested in the IRS notice
  
• Be thoroughly prepared--if your records clearly substantiate the items claimed on your return, the agent won't waste time conducting a more in-depth audit
  
• Be professional and courteous (and expect the same treatment in return)
  
• Do not volunteer information to the IRS agent; if you have a representative, he or she should respond to the agent's questions
  
• Don't lie
  
• Keep detailed records of any materials that you submit to the agent and of any questions asked by the agent
  
• Ask to speak to the auditor's supervisor if you think that the agent is treating you unfairly
  
• When you get the examination report, call the auditor if you don't understand or agree with it
  
• If you don't agree about the tax liability, meet to see if a compromise can be reached

You can either agree or disagree with the auditor's findings. If you agree, you'll complete some paperwork and pay what's owed. If you disagree with the auditor, the issues in question can be reviewed informally with the auditor's supervisor. Or, you can appeal to the IRS Appeals Office, which is independent of the local office that conducted the audit. You can appeal the auditor's findings by sending a protest letter to the IRS within 30 days of receiving the audit report. If you do not reach an agreement with the appeals officer, you may be able to take your case to the U.S. Tax Court, U.S. Court of Federal Claims, or U.S. District Court where you live.

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In tax lingo, your principal residence is the place where you legally reside. It's typically the place where you spend most of your time, but several other factors are also relevant in determining your principal residence. Many of the tax benefits associated with home ownership apply mainly to your principal residence--different rules apply to second homes and investment properties. Here's what you need to know to make owning a home really pay off at tax time.

One of the most important tax advantages of home ownership is the deduction of mortgage interest. If you itemize deductions on Schedule A of your federal income tax return, you can generally deduct the qualified residence interest that you pay on certain home mortgages taken on your principal residence. (This also applies to second homes.) That is, you may be able to deduct the interest you've paid on a mortgage to buy, build, or improve your home, provided that the loan is secured by your home. Such a mortgage is known as acquisition indebtedness by the IRS. Your ability to deduct interest depends on several factors.

Up to $1 million of acquisition mortgage debt ($500,000 if you're married and file separately) qualifies for interest deduction. (Different rules apply if you incurred the debt before October 14, 1987.) If your mortgage loan exceeds $1 million, some of the interest that you pay on the loan will not be deductible.

Although this deduction also applies to certain home equity loans secured by your home, the rules are different. Home equity debt involves a loan secured by your main or second home that exceeds the outstanding mortgages on the property. Home equity debt is limited to the lesser of:

• The fair market value of the home minus the total acquisition debt on that home, or
  
• $100,000 (or $50,000 if your filing status is married filing separately) for main and second homes combined

The interest that you pay on a qualifying home equity loan is generally deductible regardless of how you use the loan proceeds. For more information, see IRS Publication 936.

Along with mortgage interest, you can generally deduct the real estate taxes that you've paid on your property in the year that they're paid to the taxing authority. Only the legal property owner can deduct the real estate taxes. In some cases, prepaid real estate taxes can be deducted in the year of the prepayment. Taxes placed in escrow but not yet paid to the taxing authority, however, generally aren't deductible.

Note: Qualified mortgage insurance payments paid in 2007 through 2010 can be deducted in the same manner as qualified mortgage interest, but only for mortgage insurance contracts issued on or after January 1, 2007 and before January 1, 2011. In addition, the deduction is phased out if your adjusted gross income exceeds $100,000 ($50,000 if married filing separate).

Home improvements and repairs are generally nondeductible. Improvements, though, can increase the tax basis of your home (which in turn can lower your tax bite when you sell your home). Improvements add value to your home, prolong its life, or adapt it to a new use. For example, the installation of a deck, a built-in swimming pool, or a second bathroom would be considered an improvement. In contrast, a repair simply keeps your home in good operating condition. Regular repairs and maintenance (e.g., repainting your house and fixing your gutters) are not considered improvements and are not included in the tax basis of your home. However, if repairs are performed as part of an extensive remodeling of your home, the entire job may be considered an improvement.

If you make certain improvements to your home that improve your home's energy efficiency, you may be eligible for one or more federal income tax credits.

Buying a home is confusing enough without wondering how to handle the settlement charges at tax time. When you take out a loan to buy a home, or when you refinance an existing loan on your home, you'll probably be charged closing costs. These usually include points, as well as attorney's fees, recording fees, title search fees, appraisal fees, and loan or document preparation and processing fees. You'll need to know whether you can deduct these fees (in part or in full) on your federal income tax return, or whether they're simply added to the cost basis of your home.

Before we get to that, let's define one term. Points are costs that your lender charges when you take a loan secured by your home. One point equals 1 percent of the loan amount borrowed. As a home buyer, you can deduct points in the year that you buy your home if you itemize your deductions. However, you must meet certain requirements. You can even deduct points that the seller pays for you. More information about these requirements is available in IRS Publication 936.

Refinanced loans are treated differently. The points that you pay on a refinanced loan generally must be amortized over the life of the loan. In other words, you can deduct a certain portion of the points each year. There's one exception: If part of the loan is used to make improvements to your principal residence, you can generally deduct that portion of the points in the year that the points are paid.

And what about other closing costs? Generally, you cannot deduct these costs on your tax return. Instead, you must adjust your tax basis (the cost, plus or minus certain factors) in your home. For example, if you're buying a home, you'd increase your basis with certain closing costs. If you're selling a home, you'd decrease your amount realized from the sale (i.e., your sale price). For more information, see IRS Publication 530.

Now let's see what happens when you sell your home. If you sell your principal residence at a loss, you generally can't deduct the loss on your tax return. If you sell your principal residence at a gain, however, you may be able to exclude from taxation all or part of the capital gain.

Generally speaking, capital gain (or loss) on the sale of your principal residence equals the sale price minus your adjusted basis in the property. Your adjusted basis is the cost of the property (i.e., what you paid for it initially), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes.

If you meet the requirements, you can exclude from federal income tax up to $250,000 ($500,000 if you're married and file a joint return) of any capital gain that results from the sale of your principal residence, regardless of your age. In general, an individual, or either spouse in a married couple, can use this exclusion only once every two years. To qualify for the exclusion, you must have owned and used the home as your principal residence for a total of two out of the five years before the sale.

For example, you and your spouse bought your home in 1981 for $200,000. You've lived in it ever since and file joint federal income tax returns. You sold the house yesterday for $350,000. Your entire $150,000 gain ($350,000 - $200,000) is excludable. That means that you don't have to report your home sale on your income tax return.

What if you fail to meet the two-out-of-five-years rule? Or what if you used the capital gain exclusion within the past two years with respect to a different principal residence? You may still be able to exclude part of your gain if your home sale was due to a change in place of employment, health reasons, or certain other unforeseen circumstances. In such a case, exclusion of the gain may be prorated.

Additionally, special rules may apply in the following cases:

• If your principal residence contained a home office or was otherwise used partially for business purposes
  
• If you sell vacant land adjacent to your principal residence
  
• If your principal residence is owned by a trust
  
• If you rented part of your principal residence to tenants
  
• If you owned your principal residence jointly with an unmarried taxpayer

Note: Members of the uniformed services and foreign service personnel may elect to suspend the running of the 2-out-of-5-year requirement during any period of qualified official extended duty up to a maximum of 10 years.

It's nice to own stocks, bonds, and other investments. Nice, that is, until it's time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?

To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate income, such as interest? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won't get into that here.)

If you receive dividend income, it may be taxed either as ordinary income or capital gain income. Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Tax Increase Prevention and Reconciliation Act of 2005, dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. These rates are 15 percent for an individual in a marginal tax rate bracket that is greater than 15 percent or 0 percent (in 2008-2010) for an individual in the 10 or 15 percent marginal tax rate bracket. But special rules and exclusions apply, and some dividends (such as those from money market mutual funds) continue to be treated as ordinary income.

The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.

Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments--including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock--can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.

But not all ordinary income is taxable--and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, you must categorize it as taxable, tax exempt, or tax deferred.

• Taxable income: This is income that's not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you'll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
  
• Tax-exempt income: This is income that's free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that generate tax-exempt income.
  
• Tax-deferred income: This is income whose taxation is postponed until the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.

A quick word about ordinary losses: It's possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.

Let's move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term--basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.

First, initial basis. Usually, your initial basis equals your cost--what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.

Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.

If you sell stocks, bonds, or other capital assets, you'll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.

Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you'll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you'll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.

Schedule D of your income tax return is where you'll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You'll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your marginal income tax bracket, and the type of asset(s) involved. See IRS Publication 544 for details.

• Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.

• Marginal income tax bracket: Marginal income tax brackets are expressed by their marginal tax rate (e.g., 15 percent, 25 percent). Your marginal tax bracket depends on your filing status and the level of your taxable income. When you sell an asset, the capital gains tax rate that applies to the gain will depend on your marginal income tax bracket. Generally, a 0 percent long-term capital gains tax rate applies to individuals in the 10 or 15 percent tax bracket (in 2008-2010), while the long-term capital gains of individuals in the other tax brackets are subject to a 15 percent rate.

• Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.

You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.

The sale of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Also, remember that you can always seek the assistance of an accountant or other tax professional.