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For the vast majority of Americans, one of the first things you must do after taking a job offer is fill out IRS Form W4. This form tells your employer how much of your gross pay needs to be taken out of your paycheck for taxes, depending on a number of variables--which we'll cover below.
While the sheet itself is simple enough, how you fill it out has important ramifications on your taxes and whether you'll get a refund come April. Below, you'll see that though many people enjoy the rush of getting that lump-sum tax refund each spring, it can actually hurt your finances in the long run.
The specifics of IRS Form W4
In the simplest sense, the form asks you how many people you provide for -- these are termed "allowances." Here's how it works:
- You can claim one allowance for yourself (as long as no one else claims you as a dependent).
- You can claim one allowance for every dependent who is not you or your spouse (usually children).
- When it comes to your spouse, you can claim one allowance if he/she does not work, and you can choose to claim one or zero allowances if he/she does work.
- Additionally, you can claim an extra allowance if you file as "head of household." This is for unmarried persons who pay more than 50% of the costs of keeping up a home for themselves and their dependents.
Because the tax system is geared toward giving tax breaks to those with children, there are two other ways to add allowances.
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- If you pay for child care or any other type of dependent care service, and will spend more than $2,000 and plan to claim it at the end of the year, you can add one allowance.
- If you have children, you will also receive a child tax credit at the end of the year. The number of additional allowances depends on your income, marital status, and the number of children you have.
What's the best approach?
Many people are afraid of citing too many allowances when they fill this sheet out. I know some who won't claim their spouse if he/she works, and others that don't even claim themselves! The thinking behind this is simple: "I don't want the government to come after me for not paying taxes!"
But here's the thing, as long as you aren't outright lying on your IRS Form W4 the government isn't going to punish you inordinately if you claimed a number of allowances. Instead, if you didn't pay enough in taxes, you'll likely owe money when you file in April.
Many people don't like doing this. However, claiming all of the allowances you are afforded is the smart move. That's because it's actually considered a "bad" thing to get a refund in April. All this really means is that too much money was taken out of your paychecks during the year, meaning you essentially gave the government an interest-free loan for over 12 months. That's not a good deal for you.
This represents an instance in which psychology and basic math offer different perspectives. Many people love getting a hefty refund each year. They feel little to no pain when (too much) money is taken out of their regular paychecks, but a huge burst of positivity when they see their refund.
Conversely, there's not much of a positive rush from getting less money taken out of paychecks, but a definite negative feeling when you get nothing -- or owe money -- come tax time.
But if you're looking to maximize your savings and investments, getting no refund is the better approach. This way, you can invest the extra cash you get every month and let it grow over the year, instead of waiting until your refund comes. Compounded over years, this tiny change could make an important difference in the size of your nest egg.
The article Why IRS Form W4 Is So Important originally appeared on Fool.com.
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