Pay Me Now or Pay Me Later

How should you fill out your W4?W4 Exemptions:  Less Exemptions, Bigger Tax Refund or More Exemptions, Smaller Tax Refund?

Which one is better?

More and more American’s are living paycheck to paycheck than ever before. A lot of people don’t realize that one of the major components of your paycheck and the amount (besides your base pay rate whether it be hourly or salary) is the exemptions you have selected on your W4 when you first started working for your employer.

So what is a W4 and how does it work?  Form W-4 is an IRS form that your employer uses to withhold the correct federal income tax from your paycheck.  Most people start their employment career only claiming themselves as an exemption. So most people enter 1 on line A which in turn means you are having a higher dollar amount taken out of your paycheck each pay period to cover your federal tax withholding. What does this mean?  It means that your paycheck is smaller than a family with many exemptions and your tax return at the end of the year is larger.

As you start to get married and have a spouse and some children along the way, you can adjust your Form W-4 to add new exemptions.  For example, Line B of the W4 lets you claim an exemption if you are married and your spouse does not work. So now you have gone from one exemption above to two exemptions.  Next, you can enter in the number of dependents you have. So if you have three kids, each child is an exemption. So now you have gone from 2 exemptions to 5 exemptions. What does this mean?  This means that the federal government is withholding less tax money from you paycheck.  Your paycheck will be bigger each month but your tax refund will be smaller or you may end up owing and having a tax bill.

So the biggest question we get asked is which one is better. It really depends on your financial situation but I can give some examples to hopefully help you decide.

Scenario #1.  You received a much too-large refund.  Some people would say the government is using your money throughout the year and you need a larger paycheck during the year and a smaller refund at the end of the year. In this case, the best thing to start doing is adjusting your W4 each year as you experience life changes.  When you get married and start filing a joint tax return, this would be a good time to adjust your W4.  As your start to have children, you can add them on as dependents. This scenario would be great if you are needing a bigger paycheck but you are not up for a raise anytime soon.

This brings to mind the high property tax value increases that many Houstonians are experiencing.  This in turn is driving up monthly mortgage amounts for people who escrow. You may be scrambling to figure out how you are going to adjust your income and expenses for this increase. Ask you Human Resource department for a copy of your W4 and add a few exemptions. This will increase your paycheck immediately.

Scenario #2: You were hit with a tax bill from Uncle Sam or your tax refund at the end of the year was on the small side and you can afford to have smaller paycheck so your tax refund at the end of the year is greater. This works great for some people who just aren’t good at saving throughout the year and want a nice refund to go on a vacation or pay off a large bill. In this case, you can again ask your Human Resources department for a copy of your W4 and remove some of the exemptions you have such as your dependents.  This in turn will make your paycheck smaller each pay period but will give you a greater refund at the end of the year.

The IRS recommends that you review and complete a new W4 each year and when your personal or financial situation changes. Another great resource is to use this IRS Withholding Calculator to figure out the withholding that’s right for you.  The great news is W4 adjustments can be made at any time throughout the year. My best advice would be to make minor adjustments each year to avoid owing the IRS at tax time.

Summer is great time to make mid-year tax adjustments. At this point, you will have better information about your 2015 tax outlook and still have sufficient time to benefit from planning strategies.  Consult a tax professional if you want to be sure you are making the right decision.