How Does Form W4 Work?

After tax season, many people find themselves in the position where their tax preparer/accountant recommends that they change their withholdings.  This typically happens when a person has prepared their return and either has a large refund or balance due.  The rule of thumb most will use is that if either of the above is roughly 3% or more of your gross annual salary, you may need to make some changes.

How Form W4 Works
Form W4 is used to tell your payroll department how much you would like taken out of your pay for Federal Income Taxes. You will also have to fill out this form in you live in one of the 41 states that impose an income tax.  The simple way to think of this form is that every number listed on the form (called an allowance) is supposed to represent a member of your household.  So the greater the number of allowances on the W4, the smaller the amount of taxes withheld becomes.   The smaller the number is on the W4, the greater the amount of taxes taken out becomes.

What Are Allowances?
As mentioned above, a withholding allowance is generally meant to represent each member of your family that will be claimed on your tax return. Just you by yourself?  Claim 1 allowance. Are you married? Maybe you will claim 2, one for each spouse. Have 3 children? Then it could be 5, one for each spouse and 1 for each child.

Should I File Exempt From Withholding?
Generally speaking, there are very few individuals who should EVER claim that they are exempt from withholding. This is honestly one of the fastest was we see people get into trouble with the IRS and create mountains of tax debt.

The only people who should claim this status are 1) those who do not have a filing requirement and 2) those who were entitled to a full refund of ALL amounts withheld in the previous year. To learn more, take a look at Publication 505 and look at the section on  “Exemption From Withholding” and “Figure 1-A.”

What If I Am A Teenager?
If you are a student, you are not automatically exempt from having to pay taxes. If you work only part time or during the summer, you may qualify for exemption from withholding. Thus, if your total income was say $2,500 (which is less than your standard deduction) and you had $375 of income taxes withheld, it would be refunded to you. But if you earned say $8,500, you would have a filing requirement and want to have taxes taken out. At a minimum, you would probably claim 1 withholding allowance just to be safe.

How This All Comes Together At Pay Time and Tax Time
Every week that you are to be paid, your employer’s payroll department will use the number listed on your Form W4 to determine how much to take out. They do this via one of two methods listed in Publication 15, Employer’s Tax Guide.  If you go to the “How To Use the Income Tax Withholding Tables” you can see that the employer will take your withholding, look up the appropriate amount to take out based on your filing status, and then cut you a check for the rest.  Once again, the greater the number, the smaller the amount of taxes they will withhold.

Fast forward to income tax return time.  If you made $15,000 during the year and you were just fling for yourself, you would probably claim 1 exemption and the standard deduction.  For tax year 2014, the two amounts combined amounted to $10,150 with the exemption being $3,950.  Thus, you would have been taxed on $4,850.  But what if it was you and your two children?  Then your exemptions would have been $11,850.  Add this to your standard deduction (assuming the filing status is now head of household) and you would have been taxed on $0 ($15,000 income – $21,000 standard deduction and 3 exemptions).

As you can see, under the second scenario you would not have had a filing requirement.  Thus, if you only had 1 allowance on the W2, you would have had too much income tax taken out and it would have come back to you in the form of a refund.  This is why you would have possibly wanted to claim 3 allowances on the W4; so they would have taken less tax out based on the anticipated outcome on your income tax return.

Need Help?
If you need some assistance determining if you are having the correct amount of income taxes withheld, give us a call at the number in the upper right or shoot us an email via the link below.

You can also use the IRS Withholding Calculator to help you determine the correct number of allowances to claim.