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Keep More of Your Money – Don't Loan It to the IRS

Did you get a refund from the IRS last year? What about the year before? Did you feel good about getting so much money back from the IRS?

During the 2015 tax reporting season the IRS reported that the average refund was $3,366. But stop and think about what you could have done with that much money during the year. You could have put into a savings account and earned some interest on it. Or you could have made larger payments on your credit card and saved money on the interest charges.

Instead you gave the IRS an interest-free loan of your money. Why?

Last year more than 19 million taxpayers had too much money withheld from their paychecks, thus giving the IRS an interest-free loan of over $66 billion. So how can you avoid loaning your money to the IRS and keep more of it for yourself?

The key is Form W-4. Every employee has to complete one of these, and many employees don't really understand how it works, so they complete it in such a way that the IRS gets too much of their money until after they file their income tax returns. However, if you really understand how to complete the form correctly, you can get to keep more of your money in your regular paycheck.

What Is the Difference between an Allowance and an Exemption?

The primary reason that most people don't complete Form W-4 correctly is because they don't understand the difference between an allowance and an exemption. When you file your federal income tax return (Form 1040) each year, you are allowed to claim one personal exemption for yourself, one for your spouse if you are married, and one for each dependent. So if a married couple files a joint return and they have two children who live with them, they can claim 4 personal exemptions on their tax return.

In addition to personal exemptions, a taxpayer's taxable income may be reduced by a standard deduction or itemized deductions, as well as certain credits, such as the Child Tax Credit, the Earned Income Credit, child or dependent care expenses, and credits for educational expenses.

Each allowance on Form W-4 accounts for not only personal exemptions, it may also account for other credits the taxpayer may be entitled to take. So the married taxpayer mentioned above may only take 4 personal exemptions on his Form 1040, but he may be able to claim more than 4 allowances on Form W-4.

What Is the Correct Way to Complete Form W-4?

On the first page of Form W-4 is a Personal Allowances Worksheet. Since only the bottom portion of the first page must be completed and given to the employer, it is my experience that the majority of employees never really look at the worksheet. They simply enter the number of exemptions they claim on their tax returns rather than completing the worksheet and entering the number of allowances they could claim.

So let's look at the worksheet. Click on the link for Form W-4 and download a copy from the IRS for yourself. You also might want to download a copy of IRS Publication 505, Tax Withholding and Estimated Tax. It has detailed descriptions for each line of the worksheet.

Rather than discuss the details of the worksheet, let's just consider an example. Suppose an employee is paid an annual salary of $80,000, is married, and he has two children under the age of 16.

Line A – He can claim one allowance for himself. (1)
Line B – He can claim an additional allowance because he is married, has only one job, and his wife does not work. (1)
Line C – He claims an allowance for his wife. (1)
Line D – He claims an allowance for each of his two children. (2)
Line G – Since he earns less than $100,000 a year, he can claim 2 allowances for each child for the Child Tax Credit, but then he has to subtract 1 allowance because he has “two to four eligible children”. (3)

Add them up, and he can claim a total of 8 allowances on Line 5 of Form W-4.

What If You Claim Too Many Allowances and End Up Owing Taxes at the End of the Year?

Owing taxes on your tax return is not as bad as you might think. There are penalties for underwithholding, but if you use the worksheet provided, you should be relatively close to your actual tax liability.

However, if you would feel more comfortable knowing that you don't want to owe taxes and not have the money available, try setting aside a portion of each paycheck to cover any potential taxes due. For instance, since each allowance effectively reduces your taxable income by $77.90 each week, and the second tax bracket is 15%, you could set aside $11.70 a week ($77.90 x 15%) in a savings account.

Whatever way you want to do it, the goal is to be able to use your money for yourself. Don't loan it to the IRS.