Q: Tax Playa, I'm trying to figure out my W-4, and I'm very, very, confused. Help me!
Every Client I Ever Had, USA
A: This is by far the single biggest question I get from people, and it's easy to see why. Figuring out how much to withhold in income taxes is almost as difficult as doing your taxes. Thankfully, there are two good ways to figure out how many exemptions to give yourself, and what your filing status should be...
Whenever you start a new job or want to change how much tax you have taken out, you need to give a new Form W-4 to your employer. This form tells your employer three important pieces of information:
- Your basic info (name, address, Social Security number)
- Your filing status (married or single)
- How many exemptions from withholding you want to take
Cutting Through the Clutter
Unfortunately, the W-4 form itself is mostly a menagerie of calculations that most people can't understand, and leaves them with no confidence that they are doing it correctly (which results in their calling me).
Therefore, the cardinal rule of filling out a W-4 is SKIP THE CALCULATIONS AND GO TO THE IMPORTANT PART AT THE BOTTOM OF PAGE ONE. Your employer will only be concerned with this "output" part of the return, anyway. How you get those outputs is up to you.
From there, fill in what you know. That should be everything except the number of exemptions and filing status.
A Word About Filing Status
This is probably the most confusing aspect of the W-4. There are technically three filing statuses--single, married, and "married, but withhold at the single higher rate." The first and third choices will result in the same status--that third mouthful is another way to say "single."
I won't get into the math on why most married couples should list as single (it mostly has to do with claiming the broader MFJ filing brackets twice), so I'll simply ask you to rely on the guide below. It is based on your household's anticipated filing status in the spring:
- Single: Single
- Married Filing Jointly (One Worker): Married
- Married Filing Jointly (Two Workers): Single
- Head of Household: Single
- Married Filing Separately: Single
- Qualified Widow(er): Married
Two Choices on How Many Exemptions from Withholding to Claim
After the Tax Reform Act of 1986, this was pretty simple. You just put the number of people in your household, and maybe threw in a couple of extra ones if you itemized. No more. Now, you should really use one of the following tools:
- A handy IRS withholding calculator (also linked on my site)
- Use my formula
I actually think my formula is pretty simple. Here is how it goes:
- Give yourself one exemption for yourself
- Give yourself one exemption for every person in your household not filling out a W-4
- Give yourself one exemption for every $3400 in adjustments to income in 2007 (IRA deductions, student loan interest, tuition and fee deductions, educator expenses, etc.)
- Give yourself one exemption for every $3400 that your itemized deductions exceed $5350 ($10,700 if married filing jointly) in 2007. Skip this step if you don't itemize (and 70% of households don't)
- Give yourself one exemption for every $850 in tax credits you anticipate in 2007
- Take away one exemption for every $850 in other taxes (self-employment tax, penalties on early withdrawals from IRAs, etc.) that you anticipate in 2007
- Take away one exemption for every $3400 in non-wage taxable income (interest, dividends, net capital gains, net business income, net rent, royalties, pass-through income, IRA and pension distributions, taxable Social Security, etc.) in 2007
The result will be the exemptions that you should claim.
You might notice that some of those numbers ($3400, $5350, $10700, etc.) look familiar. They should. Respectively, they are the personal exemption, standard deduction for singles, and standard deduction for couples. Each W-4 exemption is equal to a personal exemption on the 1040. Additionally, the standard deduction is baked into the cake of tax withholding. Therefore, these numbers change every year with inflation.
Joe and Jane taxpayer are married. Joe works a regular job, and Jane stays home with their two kids, Bert and Ernie. Jane anticipates earning $10,000 from selling Avon after expenses as a self-employed bo-bo. They pay $3000 a month in mortgage interest, $300 a month in property taxes, $50 a month in car tax (on average), $200 a month to Our Lady of Perpetual Indulgences, and $500 a month in state income tax. They have a rental property that their tax geek tells them will result in a $10,000 tax loss. Jane is taking a class for which she paid $4000, and they have a combined $2500 in student loan interest.
That's a lot of information. This is probably one of the more complex households to dissect, so let's roll up our sleeves and get cracking:
a. Joe gives one exemption for himself (+1)
b. Joe gives three exemptions for every person in his household not filing a W-4 (+3)
c. Their adjustments to income are $4000 for tuition and fees, $2500 in student loans, and $706 as a deduction for one-half of the self-employment tax. This totals $7206, rounding out to 2 exemptions of $3400 each (+2)
d. Their itemized deductions total $48,600. Subtract off $10,700 to get $37,900. Divide this number by $3400, and it rounds off to 12 (+12)
e. They anticipate getting two $1000 child tax credits. This $2000 in credits rounds off to 3 exemptions (+3)
f. They anticipate having to pay a self-employment tax of $1406. This rounds out as a reduction in 2 exemptions (-2)
g. Finally, their $10,000 rental loss is canceled out by the $10,000 in self-employment income (0).
Add all that together, and Joe finds that he is entitled to 19 exemptions. Not bad. The first $75,300 of Joe's wages will be free of income tax, and he will come out about even at tax time.
This Isn't Laser Cutting
Many people try to fine-tune their W-4 throughout the year. Don't try, especially if you are in a non-simple household. Come out to a reasonable estimate of what your tax liability is likely to be, peg it to the correct filing status and exemption level, and get to work. If you're way off one way or another, you'll know it in the spring, and you can make an adjustment.
Many people are afraid to take a high number of exemptions. Don't be. If you have a monster mortgage, a big rental loss, and lots of child tax credits, you're entitled.
Many people understate their exemptions as forced savings, thinking they will get it back as a refund. This is stupid. It gives an interest-free loan to the government, and you're likely to spend your refund rather than save it, anyway. Rather, peg your tax withholding correctly and increase your 401(k) deferral or set up an automatic savings plan at your bank. You'll be far better off.