The federal income tax system is a pay-as-you-go system. That's one reason your paycheck looks smaller than you might think it should every payday. Each pay period, your employer withholds money from your paycheck and sends it as a tax payment to the Internal Revenue Service on your behalf. You can tell your boss how much money to withhold by filling out a W-4 form. In some cases, you may be able to claim to be exempt from federal withholding,. If you do this, your employer won't withhold federal income taxes from your paycheck.
Filling Out Your W-4
Form W-4 Employee's Withholding Allowance Certificate is the government form your employer uses to determine the proper amount of income taxes to withhold from your paycheck. It includes such information as your name, address, marital status and number of exemptions you are claiming. Your employer will withhold less if you claim married status than if you claim single, although you have the option of claiming married but withholding at the higher single rate. The more exemptions you claim, the lower your tax withholding will be. If you qualify, you can claim exempt status.
Claiming Exempt from Withholding Tax
The IRS has two qualifications for claiming "exempt" on your W-4, and you must meet both. You must have had a right to a refund of all federal income tax withheld during the previous year because you did not have any tax liability, and you must expect a refund of all federal income tax withheld this year because you don't expect to have any tax liability. You can't claim exempt on your W-4 if you can be claimed as a dependent by another taxpayer, you have more than $300 of unearned income and your total income for the year exceeds $950.
Drawbacks of Filing Exempt
It might be tempting to claim exempt from withholding because you get to keep more money from each paycheck. However, you risk getting in trouble with the IRS unless you are sure that you won't have a tax liability at the end of the year. If you miscalculate how much money you'll make for the year or how many deductions you'll have, you could be in for an unpleasant surprise come tax time. The IRS could impose an underpayment of taxes penalty if you end up owing taxes after claiming yourself exempt from withholding.
You also don't want to overestimate your tax obligation and have your employer withhold too much money. Getting a big tax refund may seem like a windfall, but it means that you have given the government an interest-free loan. Your best bet is to accurately fill out your W-4 and keep it updated as needed.
Change your W-4 as Needed
You probably had to fill out a W-4 when you first got hired, and you might not have thought of it since. After all, it's part of a whole stack of paperwork you had to fill out and sign. Don't think of your W-4 as a one-time document. If have any significant life changes such as a marriage, divorce, new baby or even a second job, you should revisit your W-4. You should also consider filing a new W-4 if there are changes to the tax law that could impact your tax liability.
It only takes a few minutes to request a blank W-4 from your employer and fill it out to reflect your new situation. Just be sure to check your pay stubs for the next few weeks to make sure your changes were implemented. Each taxpayer is ultimately responsible for making sure the correct amount is being withheld from their income throughout the year.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.