In this world, nothing can be said to be certain, except death and taxes. Ben Franklin.
Taxes are a certainty, but there's no reason to pay a penny more than the law allows. Understanding W-4 allowances and using them properly may not mean you pay less taxes, but it can put more money in your hands every pay period. Let's take a closer look at W-4 allowances, and talk about how you can use them properly, and to your benefit.
What are W-4 withholding allowances?
When you start a job, you're given an IRS Form W-4 to fill out -- often electronically. This is the piece of paper that determines how much of your paycheck will be withheld to pay federal income taxes.
In short, allowances on your W-4 should match up with the exemptions and filing status when you actually file your income taxes each year. Examples are things like dependent children and your marriage status, and head of household status. Each exemption you claim will reduce the amount of tax withheld each pay period, and should reconcile with what you actually owe at the end of each year.
The more allowances you claim, the less tax will be withheld from your paycheck; fewer will result in more tax withheld.
How should you claim?
Many people claim fewer allowances than their tax situation would support, in order to receive a larger refund each year. In theory this sounds good, but it's important to understand what you're giving up.
By claiming fewer allowances than you would qualify for based on your actual situation, you're essentially giving the federal government an interest-free loan. This can be a nice "enforced savings," but you're really not doing yourself any favors. Why is this?
Simply put, it's the time value of money. That is to say, the potential earning (or debt reduction) value of your money over the time you're loaning it to Uncle Sam for free.
If you're planning to use your refund to pay off debt, build up savings, or fund retirement accounts, it's probably better to instead claim those allowances, reduce your payroll withholding, and begin taking more more pay home each pay period instead of waiting for a refund once per year.
Small amounts can make a big difference
If you have interest-bearing credit card or loan debt, you'll pay it off more quickly and cheaply if you pay it down every month, versus a lump sum amount once per year. The reason why is simple: Every dollar you don't have paid off will cost you interest. By chipping away at it each and every month, you reduce the balance, which means less dollars given up in interest.
Don't believe it matters that much? Here's an example of how quickly it can pay off:
Let's say you have $10,000 in credit card debt with a 20% interest rate, and you're planning to pay it off with around $5,000 in tax returns each year, and will make a minimum monthly payment (usually the greater of $35, or 1% of the balance) the other months. Using this method, it would cost around $13,580 to pay off a $10,000 balance, over three years.
If you instead paid that $5 grand in monthly payments of $416.67, it would cost $12,877, and only take 31 months to do so. Not only would you pay $702 less in interest, but you'll collect more than $2 grand in extra payroll in those seven months you don't have to make payments. You can put that money to work in other ways that much sooner.
The math works the same way if you're investing the money. The sooner you invest it, the better your long-term returns should be.
A good way to invest that extra take-home money is to fund a Roth IRA each pay period. Many popular online brokers will accept direct deposits from your employer, making it really easy. Most also support regular automatic investments into stocks, ETFs, and mutual funds, further simplifying the process of creating wealth through regular investing.
It starts with one form
Instead of being too conservative and giving the government a free loan, put your money to work for you and your family. When you fill out your W-4, fill it out accurately, and take home more of your money every pay period. If your situation changes, fill out a new one, and update your allowances -- it's fine to do this if you need to.
Taxes can be a pain. I get it. But at the end of the day, it's your money. Use the withholding allowances to keep as much of it up front as you should.