The U.S. government expects you to contribute a certain amount of money each year, which is referred to as your “tax liability.”
What do they want from me?
For the average person, your taxable liability will be determined based on the pay you earn from working a job. During tax season (typically January – April), you can expect to receive a W-2 from your employer(s), which will help you to accurately file your taxes for the past year.
It is worth noting that your W-2 taxable wages tend to automatically exclude certain pre-tax deductions. Essentially, you are able to pretend that you never earned the parts of your paycheck that are put toward things such as:
- Health and dental benefits
- Contributions to Traditional (also called “pre-tax”) retirement accounts
- Pension program payments
The importance of paperwork
Hand-in-hand with a W-2 is a W-4, which you may recognize as something you had to fill out during a frantic paperwork session when you first started your job.
When you fill out a W-4, the instructions lead you to enter numbers (typically ranging from 0-2) into boxes. You may have quickly turned to Google, texted a parent, or asked someone in the HR department for advice. You certainly wouldn’t be the only one, but if that is the case, it might be high time that you reevaluate!
These numbers that you enter into the boxes represent the number of exemptions that you are telling your employer to factor into the payment that you receive throughout the year. Based on your salary and the marginal tax bracket you fall into, your employer will set aside an appropriate percentage of each paycheck to address your taxable liability. The amount of money set aside is called your tax withholding, and each exemption that you list tells your employer to reduce your tax withholding and increase the amount of money that you see in each paycheck.
The catch? Taxable liability is not a one-size-fits-all equation, and the W-4 only helps to estimate what you will owe.
Playing with the numbers
If you are like many people, you may have chosen to list 0 exemptions on your W-4. This often leads to a larger tax return in the spring, which feels a lot like free money – but it’s not!
Here’s why: If you are telling your employer to over-withhold, then each paycheck you receive will have a larger-than-necessary cut taken out to cover your expected taxable liability. While learning to live on less money is a useful skill, and receiving a large chunk of money for your tax return in the spring feels good, it’s important to consider what’s going on in this transaction. You are giving the federal government an interest-free loan for upwards of a year!
Wouldn’t you rather have more cash in your pocket each month?
It is important to note that you will ultimately pay the same amount in taxes each year regardless of your W-4 withholding, so getting a large tax return just means you went without that money all year for no good reason. That’s money that could have made some expensive months easier, or it could have been earning you even more money just by sitting in a high-yield savings account or a retirement/investment account.
All this to say: the more exemptions you list, the more cash flow in your paychecks! Take this with a grain of salt, though. Having too many exemptions may cause your employer to under-withhold, which means that you will owe money at tax time rather than receiving a tax return. If you end up under-withholding more than $1,000 of Uncle Sam’s dollars throughout a year, you will have to pay a fine to the IRS. Yikes!
The balancing act, then, is determining how many exemptions to claim. I can’t tell you what the right call is – each person is a different case, based off of their income and deductions and tax credits. What I can tell you is this:
- Follow the instructions on the W-4 for each line exemption.
- Err on the side of caution (abstain) when it comes to claiming an exemption that you’re not sure you qualify for.
When you file your taxes after the end of the year, a good goal is for your tax return (or the amount you owe the IRS) to be less than $500. If you owe taxes or receive a refund of greater than $500, and don’t anticipate a major pay raise or (financial) life changing event in the next year, you may want to consider approaching your employer about adjusting your W-4 withholding.