What to know before filling Form W-4?

We will discuss the purpose of W-4 form, why is it important to you as a taxpayer, and what are the things to keep in mind while filling it, and how often should you update it.

Purpose of a W-4 form is to inform your employer about the personal allowances you are planning to claim when you file your tax return for the current year. This information will help the employer assess the amount of taxes you will owe on your wages and withhold a proper amount every pay check.

An excellent starting point to update the W-4 is to look at your tax return for last year. Did you get a refund or did you owe money to the IRS? If you received a refund, then it means your employer was withholding too much throughout the year because your W-4 information was not accurate.

W-4 form

1040 section showing your refund/ Amount due

When too much is withheld from your paycheck, it is like giving IRS an interest-free loan. IRS is not going to pay you any interest on your excess withholding, it will simply return your excess.

If you owed money to the IRS, then there might be a penalty associated. So owing money to the IRS is also not a good thing. In a good scenario, you would neither owe money to the IRS nor get a refund.

{IF AND ONLY IF you are financially responsible – In my opinion, owing $1,000 to the IRS at year end is the best strategy.

IRS rules around underpayment and penalties change somewhat frequently, but currently – you are good if you either of the below holds good:

A. You owe less than $1,000 to the IRS along with your tax return
B. Your withholding exceed 90% of the 2015 tax OR 100% of the 2014 tax
If your 2014 AGI for 2014 was more than $150,000 ($75,000 if married filing separately), then replace 100% by 110% above.

If you have even a little doubt in your mind about your being financially responsible, then it is better to have the withholding at least as much as the anticipated actual taxes at year end.}

During 2011, three out of four income tax returns filed received a refund. IRS sent about $318 billion to taxpayers, with the average refund being around $2,900. Taxpayers could have avoided all of this and received this ‘refund’ money throughout the year (about $250 a month) simply by adjusting their W-4 withholding.

How much difference does it make? $250 a month is $125 per pay check (for most people). If this $125 is invested per pay period to earn an interest rate of 8% per year, you will have a total of $3,128 at the end of the year (in stead of the $3,000 refund from the IRS). So, you have an additional $128 – more than worth the effort to change one simple form called W-4.

(And this $3,128 would become $3,212 by the time you file your returns on 4/15 and get your refund by 4/30).

Form W-4One of the most useful line items on the W-4 form is additional amount you would like to be withheld from each paycheck – leave it blank if there are no additional sources of income apart from the employment wages. But use this to get additional tax withheld if you have other income sources like stock dividends, stock sales capital gains, rental income, self employment income etc.

Let us take stocks for example – you make money either by the dividends paid by the stocks or when you sell the stocks. Dividends are always taxable and sale proceeds are taxable if you made a profit. In United States, brokerage firms are not required to withhold taxes on these earnings but you are required to pay taxes.

Taxes are due when income is earned (and not when you file taxes), so either you make ‘estimated quarterly payments‘ every quarter OR you have additional tax withheld from your paycheck to cover these income streams from stocks.

To conclude – you can submit a new W-4 free of cost as many times as you like throughout the year. You should consider completing a new Form W-4 every time your personal or financial situation changes. Most large employers allow submitting a new W-4 online (to replace an existing W-4).

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