If you haven't started working yet, you probably haven't heard about the W4 form. What is it? It is a form you file with the IRS to let them know how much in taxes (income, social security, medicare) should be withheld from your paycheck. The form is pretty self explanatory: you can enter a 1 if no one can claim you as a dependent, if you are single with only one job, etc. Then you add up all your allowances and you submit the form. The higher the number of allowances you claim, the less will get withheld from you (meaning the more money you receive with each paycheck). Will this affect how much you pay total in taxes? Probably not since the difference between how much you are supposed to pay and how much you have paid will be reconciled when you file your taxes the next April.
Many people are mistakenly excited when they find out they get a tax refund during tax season. Like I explained in my tax strategies post, however, getting a tax refund essentially means you just gave the government an interest-free loan. While the U.S. government can probably use all the help it can get, this comes at a loss to you. If you have received a tax refund in the past, you should try to adjust the number of allowances you claim on your W4 to most accurately match your tax payments. This way you can take most of your pay home in cash when you are paid.
If you are working full-time, this is probably not a big issue since you just fill out the form and claim the allowances that are totaled on the sheet. If you are only working part time, at an internship for example, too much of your pay will probably be withheld since you aren't working for that amount of money all year round. You can try to adjust your allowances claimed on your W4 to correct for this. One easy way to do this is to use the IRS withholding calculator which will ask for your salary, previous pay in the year, expected pay after your current job, and taxes already withheld to try to give you an estimate of an appropriate exception number to claim. My calculator told me to claim 7 allowances, and I work part-time jobs during the school year.
Why don't you just claim 20 allowances on your W4? Well, in the past, employers would have had to submit all W4s claiming more than 10 allowances directly to the IRS. I believe it has since stopped, but just claiming an extremely large number may put you under their scrutiny. Secondly, there may be a tax penalty if you underpay your taxes too much. The penalty for 2011 applied if your tax payments for 2011 did not equal at least the smaller of 1) 90% of your 2011 tax or 2) 100% of your 2010 tax or if the amount you owe in taxes when you file your return is less than $1000. So as long as you pay at least 100% of the tax you paid for the previous year, you should be in the clear and you could potentially get away with paying less tax if you are making less money this year (but still meeting 90% of your obligation).
How much are you charged if you don't qualify for the penalty waiver? The rate of penalty is around 3-4% for 2012 depending on the months when higher taxes should have been withheld. This means that if you can earn more than 3-4% on the money you take home, you shouldn't really care if you pay the penalty or not. Assuming you just don't withhold any money, put all the extra cash you get in the stock market and say it earns 7% over the next year and pay the 3-4% penalty on the tax you owed, you would be better off. Of course, you can't say for certain that you will earn that 7% but the cost doesn't seem very high. Some of you might be willing to pay that amount to get your money faster to begin with.
Regardless, make sure you take a closer look at your W4 when you first sign up. Even if you already filled it out, you should be able to change the number of allowances you claim in between pay checks. Double check to see if you have claimed an adequate amount so that you don't have to wait for your money until next April.
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