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Updated on Friday, March 4, 2016
You and a co-worker earn the same amount, contribute the same percentage to a 401(k), but someone she’s getting more deposited into her bank account? What gives? The answer lies in one of the many pieces of paper you filled out during the first day on the job: the W-4.
What is a W-4?
When you start working for a company, they have to determine how much of your paycheck to withhold for taxes. While the company has basic tax withholding guidelines they need to abide by, paychecks can be customized to employee’s situations. This done by filling fill out a W-4 form. Your HR department keeps this IRS form on file, and uses it as a guideline on how much to withhold and send to the IRS every payroll period.
Sounds simple enough, what can go wrong?
The main culprit is caused by not claiming enough, or too many, dependents. On the form, you can state how many people in your household depend on your income (in tax language, a “dependent”). If you are married and have two kids, then this number would be four. You can then advise HR that you want to claim four dependents. In doing this, you will receive a larger paycheck so you can support your family. However, in selecting a larger number, you may not be having enough taxes withheld, which will lead to you owing money with your tax return in the Spring.
The opposite is also true. For those people who do not have anyone to claim as a dependent or do not want to owe taxes, they claim zero dependents and receive a smaller paycheck. In doing this, their tax bill in the spring is minimal, or they even receive a refund. In some cases, this refund can be thousands of dollars.
Why wouldn’t you want a big tax return?
Getting unexpected money is great. Even if it’s expected, not knowing the amount can be a great surprise. But the thing that gets overlooked when discussing tax refunds, is that this money was yours all along. By overpaying in your taxes – by not claiming enough dependents – you have been loaning money to the government, and they pay it back to you in the spring – with no interest included. It’s like putting extra money in an investment that pays 0% interest; with the only time you can draw it out being in the spring when you file your taxes.
For some, it can be forced savings to receive that money in a lump sum versus spread out over the year. They then put that money into their investments or savings account, and don’t have to worry about monthly savings. However, they miss out on investment growth over the entire year. For the most part, it’s not a good strategy to get a big tax refund at the end of the year.
So how should I file, or revise, my W-4?
Every situation is unique. You’ll want to look at your last year’s tax return, and how much money you are making compared to last year. If you are making a similar amount, then this is an easy exercise. See how much you received in a refund / amount owed divide that by 12. Then approach HR and ask them to withhold, or give you, this amount every paycheck (if you get paid monthly).
For example, let’s say that Andrea earns $50,000 as a medical resident but owed $1,200 in tax payments when she filed her taxes. She should go to HR and ask them to withhold an extra $100/month from her paycheck, and then her liability at tax time would be minimal.
For another example, let’s say Chelsea got a raise at work and then be conservative until she goes through her first tax season with her new income. Let’s say she went from $37,500 to $55,000 in her promotion. As a single individual in Nevada, she doesn’t have to worry about state income taxes, but she did jump from the 15% to the 25% Federal tax bracket. She should be asking HR to withhold 25% of her increased pay, not 15% in order to adequately cover her increased liability. She may find that this will be too much come tax time, but she’ll receive a small refund. It will also allow her to fine-tune her withholding for the following year.
There’s nothing worse than getting a promotion and then paying taxes in the spring to remind you that you got paid more!
Confused? Here’s where to find help
It can be tricky, especially when your situation changes, to understand what numbers to use. The IRS understands this, and wants your situation to be accurate, so they have provided a calculator: https://apps.irs.gov/app/withholdingcalculator/. While it is quite detailed, it will give you an accurate estimate of whether you will be owe money, or receive a refund.