Adjust Your Payroll Withholding with Form W-4

Clients often ask , “How many allowances should I claim on my W-4?”. This may sound like a simple question, but it is very difficult to answer.

Form_W-4

The bottom portion of page 1 Form W-4 (the portion you give your employer) appears to be very straight forward. You can check in Box 3 whether you are “Single” or “Married”, and then you might think you would put the same number of exemptions in Box 5 that you show on your tax return. This would only work out if you only had one job, your spouse didn’t work, you didn’t itemize your deductions, your dependents don’t qualify for the child tax credit or dependent care credit, or the various other available deductions and/or credits. In other words, the straight-forward answer is only right if you have a very simple, basic employment situation and tax return.

For most employees, the number of allowances in Box 5 needs to be adjusted to keep from withholding way too much, or way too little income taxes.

While there are different tools and methods to determine your Form W-4 settings, it is helpful to understand that they all incorporate two basic steps:

  1. Determine your unique tax situation and the total amount of income taxes required, and then
  2. Set, monitor, and adjust your Form W-4 allowance settings to match this amount.

Let me give you some examples, starting with the easiest situation.

MORE SIMPLE…  The first situation is where you can anticipate your employment and tax situation to be the same as the prior year. The first step is basically done, and the amount of taxes you had to pay, or the amount of refund you received, is the amount you need to have changed by your W-4.

Example A – You finished your tax return and have a $1,800 Federal refund. You anticipate the same employment and tax situation for this next year. To have $1,800 less withheld from your wages this next year, you divide the $1,800 by the number of remaining pay periods (i.e. 9 months semi-monthly payroll would be 18 paychecks). You can then change your W-4 allowance settings.

On your Form W-4 Box 5 Allowance entry, understand how changes affect your tax withholdings:

  • Decreasing the number of exemptions will increase the amount of taxes withheld.
  • Increasing the number of exemptions will decrease the amount of taxes withheld.

The amount you need to change your exemptions will depend on the amount of your wages and your current W-4 settings. If you want to keep it easy, you can increase your exemptions and look at the paystub on your next paycheck to see if your withholdings changed by the correct amount, and then make further adjustments if needed.

Alternatively, you can look at your current W-4 settings and then look up the corresponding tax withholding tables (back of the IRS Circular E) and calculate the allowance change needed. In the Example A above, if your current W-4 settings were “Married, Claiming 1” with a gross wage of $1,500 semi-monthly pay period, changing exemptions and withholdings from “1” of $170 to “5” of $72 ($98 decreased withholding and increase in the net check you receive).

It should be noted that payroll systems do not use the published tax tables, but compute withholdings in the way that the tables are computed.  If you use the withholding tables, expect there to be a small difference.

Kiplinger has an online easy-to-use calculator to help you determine the amount to adjust your W-4 allowance.

MORE  COMPLEX…  The more complex situation occurs when one of many events occur that will change your employment and/or tax return. Some of the more common things are:

  • Change in Employment…
    • New job
    • Additional job
    • Unemployment
  • Change in Marital Status…
    • Marriage
    • Divorce
  • Change in Dependents…
    • Birth of Child (additional dependent, child tax credit, child care credit)
    • Adoption of Child (similar to child’s birth plus credit for qualifying adoption expense)
    • Child turning 17 (no longer qualifying for the child tax credit)
    • Child moving out (loss of dependent)
    • Child going to college (education deductions and/or credits)
    • Child graduating from college (loss of dependent and education deductions and/or credits)
  • Change in Business –
    • New Business Investment
    • Change in Profitability of Business
    • Closing of Business Investment
  • Change in Investments –
    • Sale of Investments… Gain? or Loss?
    • Change in amounts contributed to retirement accounts
  • Etc…

Anything that will impact your tax return and the amount of taxes you have to pay will affect whether or not you are withholding enough, or too much, taxes from your paycheck (e.g. your W-4 settings).

The first step of “determining your unique tax situation and the amount of income taxes required” becomes more difficult as more circumstances change, but it is necessary if you want your withholdings to be accurate.

This process is what the top of Form W-4 page 1, and Form W-4 page 2 helps you do. Here is a link to IRS Form W-4.

For additional help, consider using the Internal Revenue Service’s online withholding calculator. It may seem too complicated, but because it incorporates the complexity of income taxes in many of the situations I mentioned above, it has to step you through the process systematically.

Example B – You are having a child (congratulations!) and want to change your Form W-4 to reflect this new change in your life. This one event could impact your tax return in several ways:

  • If you itemize, and have substantial medical expenses, you may have additional deductions on your Schedule A.
  • You will also have an additional “Exemption” deduction.
  • If you and your spouse both work and have child care expenses, you will get a “Dependent Care Credit”.
  • If your income isn’t too high, you will receive a $1,000 “Child Tax Credit”.
  • If your income is low enough, you may also qualify for the “Earned Income Credit”.

One event, but many possible outcomes depending on your situation. If we assume that income and the Standard/Itemized Deductions will stay about the same, the table below reflects the estimated impact of a first child to a couple that spends $6,000 a year on child care:

Tax_Impact_New_Child

Remember, Step 1 in adjusting your Form W-4 is to determine your unique tax situation, and in this example, depending upon your income, you can estimate how much less your Federal income tax will be. For most people, their total Federal withholdings in the above Example B can be reduced by about $200 each month.

Step 2, then, is to change your Form W-4 allowance settings accordingly. If your income comes from different employers, you can choose to adjust any or all related Forms W-4. Remember not to assume that your initial allowance setting changes on your Form W-4 will be correct. Monitor your pay stubs and make any follow-up adjustments as needed.

Let us help you!  The first step can become complicated as your tax situation becomes more complex. We have the knowledge and tools to help walk you through this process painlessly.

Rick

Circular 230 Disclosure: This is to advise you that, unless expressly stated, nothing in this communication (including any attachment or other accompanying materials) was intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding any federal tax penalties, or for promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to anyone.

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