When you start a new job, your employer will ask you to fill out a packet of employment paperwork, which includes IRS Form W-4. Knowing how to fill out your W-4 correctly can maximize your paychecks without leaving you with a tax bill at the end of the year. Getting it wrong can result in giving an interest-free loan to Uncle Sam, or worse -- owing a big pile of money at the end of the year.
What is Form W-4?
IRS Form W-4 is designed to let your employer know how much should be withheld from your paychecks for Federal income taxes. Most of the information on your W-4 is standard identification information, such as your name, Social Security number, and address -- but the important part is your "allowances" listed on line five.
Basically, each allowance you claim tells your employer to withhold less money from your paychecks. Fortunately, there's a worksheet provided with your W-4 that can help you determine the correct number of allowances to claim.
An accurate number of allowances is important to determine because it can help avoid a tax bill, while simultaneously maximizing your paychecks. If your withholdings are too low, you'll end up owing money to the IRS at the end of the year, which is no fun (believe me). On the other hand, if too much is withheld from your paychecks, it's not a good thing either, as we'll see shortly.
Why not just claim zero exemptions and get a big tax refund?
A popular, but misguided, strategy is to claim zero exemptions on a W-4, no matter how many you qualify for. While this will result in a bigger tax refund -- especially if you qualify for multiple allowances -- it's not a good thing.
Essentially, a large tax refund is the same thing as giving the IRS an interest-free loan of your money. For example, let's say that you decide to claim zero exemptions, and end up with a $4,000 tax refund next spring.
If you had claimed the correct number of exemptions, your paychecks would have been higher by $333 per month throughout the year. Furthermore, if you had chosen to invest that money every month instead of letting the IRS hold onto it, and managed a reasonable 5% rate of return, you would have nearly $100 more by the time you'd get your tax refund.
Your W-4 should change along with your life
Too many employees simply fill out a W-4 when they get hired, and forget about it. And I'm as guilty of this as anyone. When I got my first job as a high school math teacher, I filled out my W-4 when I got hired, and didn't update it once during the five years I stayed with that employer.
The correct approach is to contact your human resources department and update your W-4 data whenever you have a major life change. If you get married, get divorced, have a child, get a second job, or change your filing status to head of household, you need to update your information to ensure accurate Federal withholding.