Each time you start a new job, you are required to submit a W-4 and I-9 form. Those forms tell your employer how much tax to deduct from each paycheck and verify that you are a legal US resident who can take a job. Most of us only spend a few minutes on those forms but don't understand the long-term ramifications.
Taxes Owed vs. Tax Deductions
Each year, your taxes are going to be the same no matter how much is deducted from each paycheck. If you have a low number of allowances, your employer will deduct more from each paycheck to be sent to the IRS. If you choose a higher number, your employer will deduct less from each paycheck. That does not impact your taxes owed to the government at the end of the year.
The taxes you owe to the federal government are determined based on your total gross income. That is income before any deductions, other than tax deductible items that lower your tax bill. Taxes are calculated using a graduated scale. That means you pay a higher tax rate per dollar on higher income. It it important to understand, though, that earning more will not increase your taxes on money you already earned. Someone who makes $20,000 per year and someone who makes $2,000,000 per year pay the same rate on their first $10,000 of income.
Payroll Tax Deductions – How Many Allowances Should You Choose?
So that form you fill out when you start working, form W-4, actually does a lot. (You can update your W-4 any time you like. I updated mine last year to lower my allowances.) It directly impacts your take home pay each time you get a paycheck.
Some people have different philosophies, but I believe you should try to match your payroll deduction as closely as possible to your actual taxes owed, erring on the side of getting a refund. If you take too many allowances, you will owe taxes at the end of the year. If you take too few allowances, you will get a refund back from the IRS.
Think about it. If you get a refund of $2,000, you get $2,000 at the end of the year. Sure, you gave the IRS an “interest free loan,” but with current interest rates, that probably cost you less than $5. Planning to owe the IRS, though, means you have to really plan out what you owe and save up to pay Uncle Sam on tax day. I would happily give up $5 to get a refund at the end of the year rather than owe money that will likely have to come from an emergency fund.
What I Do
For most single adults, it makes the most sense to take 1 allowance. However, I make money from a handful of side projects, and I would rather have the extra taxes taken out of my regular paycheck to cover my taxes, so I take 0 allowances.
For my 2012 taxes, even taking 0 allowances, I ended up owing about $800 in taxes from income on my blogging projects, Denver Flash Mob, and DJing. This is the first year I have ever owed come tax time, but at least it means I am making more on the side!
What You Should Do
It is up to you to decide which option is best. You can also talk to a tax professional to decide. If you want a little extra help deciding, BankRate.com has a great payroll deductions calculator to help you through the math. Just be careful not to be too conservative and get too big of a refund, or you will put a big crunch on your monthly budget.
What do you do? Let us know in the comments.
Originally written November 9, 2008. Updated March 27, 2013 and November 11, 2015.
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