Reader AJ recently sent me the following question:
How many deductions should you make on your W-4? My HR person suggested that I only take 1 deduction because I “would get a bigger refund.” Just looking it over though, I didn’t seem to get that huge of a refund this year (about $600) to merit having so much taken from each paycheck. I could take at least 4 deductions now with the family and could have up to 7 by the time I start my full-time job after pharmacy school. Of course, I will be making a lot more then so would it come back to bite me come April 15? These are the things I ask myself during a boring lecture.
AJ’s question is one a lot of my friends and family ask, but they always seem to get a different answer depending on who they ask. A lot of people say, like AJ’s HR person, that by taking the least amount of deductions you can “get a bigger refund” come tax time. The bigger refund, however, is only the result of Uncle Sam taking too much from your paycheck each month and then being forced to hand you the excess in April.
There are a few things wrong with this way of thinking.
The first (and biggest) problem is that this method gives Uncle Sam an interest-free loan throughout the year. Banks don’t seem to do this, so why should you?
The second biggest problem is that instead of giving away free money, you could actually be earning money on that amount. Imagine, for instance, that Uncle Sam was taking $100 too much from each paycheck of yours. After 24 paychecks or so you will have given the Government $2,400. When tax season arrives, the Government will give you your $2,400 back, but not a cent more. However, if you had filled out your W-4 correctly and invested that $100 in just an online savings account earning about 5.25% you could earn yourself a cool $60. It doesn’t seem like a lot, but it’s better than giving it to Uncle Sam – which is what you are effectively doing by giving HIM the free loan.
So how should you fill out your W-4? My advice is to work backwards.
Step 1: Look at last year’s tax return, use a simple online calculator, or even your favorite tax program to estimate what your taxes are going to be for the year.
Step 2: Using that amount, you’ll want to choose the amount of deductions that will (honestly) allow your employer to withhold enough taxes so that by the end of the year you’ll owe $0 in taxes, and Uncle Sam won’t owe you a dime either. You can use a simple W-4 calculator like this one, or go for something fancy like this one. Whichever one you choose, you can tweak the amount of deductions made and see what the final deduction amount will be after one year. Remember, your goal is for your withholdings to match your estimated tax bill.
That’s it! Only two steps.
Now of course your situation will change. You’ll earn a little more, or be able to deduct a little less in April, but hopefully by the time taxes are due, you’ll only owe a small amount. And if you’ve been saving that extra amount that would have normally been deducted, you can even pay that small amount due with your earned interest!