The trick, however, is figuring out just how many exemptions to claim. This question came up in a recent email from a reader named Ryan:
“I am pretty new to personal finance and love your podcasts. As a new college grad, they are really helping me organize my finances and learn important information about handling money most figure out later on by trial and error. As tax season is coming up, I had a question about maximizing your withholding on your W4. I have heard that the optimal tax return you should be looking for is $0. This means that you are not paying any taxes which is good, but also you aren’t allowing the government to take too much out of every paycheck as a no-interest loan. So you get more money per paycheck and can invest it instead of waiting until tax season to get a big lump sum return. Is there anyway to estimate what I should put down on my W4 in order to try to get the smallest return possible? Pretty much the only thing I know about filling out a W4 is the higher the number you write on the form, the fewer taxes are taken out. I didn’t know if there was an easy way/website which could help you estimate how many allowances to put to minimize tax return and maximize each paycheck.“
As luck would have it, the IRS offers a free calculator to help you estimate the number of exemptions you should claim. Let’s start with the W4 form. You can get it on the IRS website, and then we’ll look at the calculator.
The form comes with a worksheet that you can complete in order to determine the proper number of exemptions. There are also instructions to help guide you through the process. However it’s easy to make mathematical errors or to misinterpret certain calculations. If you do, you can either end up having too much tax withheld, or not enough. As the listener above mentioned, this means you’re either giving Uncle Sam an interest-free loan or writing a big check at the end of the year.
You can more accurately calculate the number of exemptions you should take using the IRS Online Withholding Calculator. This is a five page exercise in which you simply fill in required numbers, and the IRS will calculate your exemptions for you.
Let’s go through the calculator one page at the time. Don’t be overwhelmed by the number of questions the site requests. All you need to do is fill in the boxes with the necessary information, and the calculator will give you what you need.
For the purposes of this post, I entered fictitious information, so you can see an example of what the final output will be.
IRS Online Withholding Calculator–Page 1–General Information
Page 1 requests basic information, similar to what is included on your tax return (my answers are bolded).
What filing status will you use on your 2017 Income Tax Return?
- Single ____
- Married filing joint return __X__
- Married filing separate return ____
- Head of Household ____
- Qualifying widow(er) ____
- Can someone else claim you as a dependent on his or her tax return? __No__
You just check the applicable questions. Then move on to the next page.
IRS Online Withholding Calculator–Page 2–General Information (continued)
This page continues with general information questions, and gets a lot more specific.
Select the total number of jobs in which you and your spouse are currently or will be employed. (Enter military retirement pay or taxable pensions as additional separate jobs.):
- Check box if you or your spouse held a job this year but are no longer employed in that job____
- Check box if you or your spouse contributed to a tax-deferred retirement plan this year __X__
- Check box if you or your spouse contributed to a cafeteria or other pre-tax plan this year____
- Check box if you or your spouse received a scholarship or fellowship grant this year that must be included in gross income____
- Select the number of dependents (other than yourself and your spouse ) you will claim on your tax return __2__
- Check if:
____You will be 65 or older on January 1, 2015 ￼You are blind
____Spouse will be 65 or older on January 1, 2015 ￼Spouse is blind
- Child and Dependent Care Credit
Select the number of qualifying persons for this credit: __2__
- If you plan to claim this credit, enter an estimate of work-related child and dependent care expenses: $ 12,000.00
- Child Tax Credit – Select the number of eligible children: __2__
- Other Credits
Enter the total value of tax credits other than the credit for child and dependent care expenses and the child tax credit: $ ____.00
Let’s spend a minute on the last question, “Other Credits.” The calculator gives you a link that you can click to see exactly what those credits are, as well as the IRS publications that explain them.
As a general rule, I would avoid attempting to include any of these other credits in your exemption calculation unless you are certain they apply. There are at least three reasons why I recommend this:
- Calculating the credits can be ridiculously complicated.
- It may not be possible to know with any reasonable certainty that your credit calculations will be correct because so much rides on your end-of-year numbers and a host of sub-calculations.
- As any professional tax preparer will tell you, most of these credits are best prepared by a good income tax software program.
With that caveat in mind, here is a list of those other credits:
- Credit for the elderly or the disabled
- Education credits
- Adoption credit
- Foreign tax credit, except any credit that applies to wages not subject to U.S. income tax withholding because they are subject to income tax withholding by a foreign country
- Retirement savings contributions credit
- Mortgage interest credit
- General business credit
- Qualified electric vehicle credit
- Credit for prior year minimum tax if you paid alternative minimum tax in an earlier year
- Earned income credit, unless you requested advance payment of the credit
- Health coverage tax credit
- The Premium tax credit for those who purchase health insurance through a Health Insurance Marketplace
- District of Columbia first-time homebuyer credit
IRS Online Withholding Calculator–Page 3–Income and Withholding
This is where the calculator begins to ask specific questions in regard to income and withholding. You have to be careful to be as accurate as possible here, as the exemption totals that you will get from the IRS will be no better than the input you have provided.
For each job you now hold (and for each taxable pension you receive)…
Enter the gross wages, salary, and tips (excluding bonuses but including taxable fringe benefits) you expect to receive in 2015 (Enter military retirement or taxable pensions as separate jobs.):
- Job 1: $50,000.00
- Job 2: $50,000.00
- Enter any bonuses you expect to receive in 2015: Job 1 $.00 Job 2 $.00
- Enter the total Federal income tax withheld to date in 2017 (including amounts withheld from bonuses or which you expect to have withheld for bonuses): Job 1
$500.00 Job 2 $500.00
- Enter the Federal income tax withheld from your last salary payment: Job 1
$250.00 Job 2 $250.00
- Select how frequently you are paid: Job 1: Bi-monthly Job 2: Bi-monthly
- Select the date closest to when you first held this job in 2015: Job 1: January 1 Job 2: January 1
- Select the date closest to when this job will end in 2015: Job 1: December 31 Job 2: December 31
- Enter the total of any other taxable earned income you received or expect to receive in 2017: ____
- Enter any unemployment compensation you received or expect to receive in 2017: $ .00
- Enter an estimate of any other nonwage income (such as dividends, interest, or alimony received) you expect to receive in 2017. Do not include amounts you included in earned income above: $ 5,000.00
- Enter an estimate of your 2017 adjustments to income, including alimony paid, deductible IRA contributions, and education loan interest: $ .00
IRS Online Withholding Calculator–Page 4–Deductions
Deductions are allowable reductions in your taxable income. Since it’s early in the year, you will have to make reasonable estimates as to what your deductions are likely to be for the full year. You can use last year’s tax return to help you come up with these numbers.
- If your standard deduction, $12700, is more than your total itemized deductions, your standard deduction will be used to calculate your withholding. Otherwise, your total itemized deduction amount will be used.
- If you want to use your itemized deductions to calculate your withholding, even if they amount to less than your standard deduction, check this box:____
Enter an estimate of your 2017 itemized deductions:
- Medical and Dental Expenses: $.00
- Taxes You Paid: $5,000.00
- Interest You Paid: $10,000.00
- Gifts to Charity: $5,000.00
- Casualty and Theft Losses: $.00
- Job Expenses and Most Other Miscellaneous Deductions: $.00
Other Miscellaneous Deductions: $.00
IRS Online Withholding Calculator–Page 5–Your Results
Based on all of the numbers that you input into the calculator, the IRS will give you a specific number of exemptions for both you and your spouse. There is no need for each spouse to complete this calculation individually.
In addition to providing your exemptions, the calculator also provides a very specific estimate of what your income tax liability for the year will be. Also note that in our example, the first spouse is given two allowances based on the information provided, while the second spouse is given seven. It then provides you with the tax refund you should expect based on making these changes in your exemptions ($100).
Based on the information you previously entered, your anticipated income tax for 2017 is $4,691. and your projected withholding is $1,500 Your anticipated underpayment is $3,191. Since it’s December, any changes to your withholding that you request on Form W-4 may not go into effect until next year.
You should try to have your withholding match your actual tax liability because if not enough tax is withheld, you will owe tax at the end of the year and may have to pay interest and a penalty. The amounts of your anticipated income tax and underpayment indicate that you might be liable for such a penalty, which you may be able to avoid or reduce by making an estimated tax payment as soon as possible. For more information see Publication 505, Tax Withholding and Estimated Tax (use the link at the bottom of this page or the search area to the left to get an electronic copy).
Tip Be sure to review your withholding at the beginning of 2018 (or any time there is a change in your tax situation). If you follow the above recommendation and do not check your withholding at the beginning of next year, your withholding for 2018 might be incorrect.
Following is a recap of information entered on the preceding pages on which the above advice is based.
- Prepared: December 6, 2017
- Filing Status: joint
- Someone else can claim you as a dependent: no
- Number of jobs: 2
- Number of dependents: 2
- Will you be 65 or older 1/1/2018: no
- Are you blind: no
- Spouse will be 65 or older on 1/1/2018: no
- Spouse blind: no
- Child & dependent care credit qualifying persons: 2
- Child & dependent care credit expenses: $12,000
- Eligible children for child tax credit: 2
- Other credits: $0
- Total salary: $100,000
- Total tax withheld to date: $1,000
- Total tax withheld from last check: $500
- Total earned income other than salary: $0
- Nonwage income: $5,000
- Adjustments to income: $0
- Total itemized deductions: $20,000
- Projected additional withholding if you do nothing: $10,500
Once again, please understand that this looks a lot more complicated than it actually is. It took less than 10 minutes to calculate the exemptions using the IRS calculator. Had I done this manually with the W4 worksheet, it would have taken a good deal longer, not the least of which since I may not have fully understood the questions being asked or the information requested.