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If you employ any number of people, you’re probably used to answering a solid number of questions about Form W-4.
One of the key pieces to the W-4 is each employee’s withholding number. Or in other words, the amount withheld from their pay for federal income taxes. Choose the wrong number and an employee can end up being shortchanged on their net pay or woefully behind on their tax obligation.
As an employer, the more you know about how withholding works, the better you can help your team navigate this mathematical mystery.
Now, let’s walk through the formula that will help your employees land on the best possible number.
Wait, why should I care about this random number?
In case you’ve gone on a massive news purge, Congress passed sweeping new tax legislation in 2017 that changed every nook of the tax code. One of the most significant changes are the lower tax rates that mean many employees need to tackle an updated Form W-4.
Form W-4, or the “Employee’s Withholding Allowance Certificate,” is where your team determines how many personal tax allowances they’ll claim. That number of allowances is often known as a withholding number.
Your team will use the Personal Allowance Worksheet on page three to calculate it. Here’s what it looks like:
What does a “good” withholding number look like?
Zero, one, two, or three? It depends.
It’s a Goldilocks situation.
The vast majority of CPAs, personal finance experts, and any run-of-the-mill tax geek will say that the right amount is what will get someone as close to meeting their tax liability as possible.
Employees shouldn’t withhold so much that Uncle Sam gets an interest-free loan and they wind up with a big refund. The IRS found that the average refund in 2017 was a high $2,931.
But, they also don’t want too little withheld and then have to cut a big check at tax time. The “just right” amount of withholding will come close to the tax liability on their tax return, resulting in either a small amount due or a small refund.
So let’s just move on and forget about refunds. Right?
But it also depends on your financial needs.
Here’s the thing—while the conventional wisdom to choosing a withholding number is to find a balance between a higher paycheck and meeting your tax and other financial obligations, I can totally understand the arguments in favor of more withholding to guarantee a big refund at tax time.
Why? Because it may help some people meet their financial goals.
Let’s say someone needs a boost to their IRA or has to pay off some credit card debt. What are the chances they’ll do either of those things if they have a little extra money in each paycheck? A large refund may be just the thing a motivated individual could use to meet a financial goal.
Receiving a tax refund can make a huge difference to how people think about money. Consumer psychologist Kit Yarrow told Forbes that it can either become “an enforced savings plan” or a bunch of money that people spend “more liberally” than immediate cash. In fact, the number one thing people said they planned to do with their tax refund was stash it into a savings account.
So how can your employees pick the most appropriate number?
In general, folks often claim one personal allowance for themselves and an additional allowance if they have a spouse who doesn’t work. Additional allowances may be taken if individuals file as head of household, qualify for the Child Tax Credit, or have other dependents.
Do your employees want a larger refund? They can run through this quick exercise to see if aiming for that large pot of gold makes sense. Kit Yarrow suggests the following:
- Write down what you said you were going to do with your refund last year.
- Compare that aspirational list to what actually happened to the money.
This will help your team figure out if they were productive with their refund, and how they want to tweak things this coming tax season.
Hand out this list of questions.
Once your team figures out if they want to aim for a higher refund, give them a few more questions to think about. If an employee can answer each one, it will help them determine their ideal withholding number.
- Filing status: Single? Married filing jointly? Head of household?
- Employment status: Does your spouse work? Do either of you have a second job?
- Rugrats: Do you have any?
- Deductions: Do you itemize deductions on your tax return?
- Other income: Do you have income from other sources, like a business or trust?
Not that there are ever simple answers. Here are two scenarios to bring the whole withholding number calculation to life:
1. A single taxpayer with one job, no children, and no non-wage income.
If they claim one personal allowance, this will most likely result in a refund. If the taxpayer would rather have a slightly higher paycheck, they can claim two personal allowances. However, they may have tax due when they file their tax return.
But remember, IRS penalties may apply if you owe too much additional tax at the end of the year. Individuals can generally avoid such penalties as long as they owe less than $1,000 after subtracting their tax payments and credits, or if they paid estimated tax of at least 90 percent for the current year or 100 percent of the tax for the prior year—whichever amount is smaller.
2. Two married taxpayers who both work and have no children.
Although this sounds like a simple scenario, it depends primarily on what each person earns. To avoid a year-end tax bill, your employee should complete the Two-Earners worksheet on Form W-4 to determine their additional withholding.
The key to the whole withholding debate? Your employees’ withholding numbers depend on their unique tax situations and may need to be revisited every year. Consider sharing the Personal Allowances Worksheet with your team so you can get them thinking about what their ideal number should look like.
As the years pass, they’ll thank you for your help with this mysterious—but very surmountable—numerical dilemma.
This article contains general information but is not intended to be construed as tax advice. Please have your employees consult with a tax professional to help them make the most informed choices for their various situations.