Would You Like an Immediate Pay Raise? Change Your Withholding Allowances

by
Jul 23, 2010


The Bottom Line Increasing withholding allowances will increase net pay and put more cash in your pocket right now.

Would you like to give yourself an immediate pay increase? I would bet that the majority of those reading this question would answer in the affirmative, followed by the inevitable question: How? Well, it isn't easy to receive an actual increase in gross income, but it is possible for most individuals to increase net pay by making a few simple changes to their withholding allowances. Let's take a look:

What is a Withholding Allowance?:

Federal withholding allowances are deductions in taxable income that affect a taxpayer's level of federal tax withholding. They are similar to exemptions, except that, unlike the exemptions you claim when you actually file your taxes, withholding allowances are claimed from your paycheck and affect your weekly take home pay. Along with your marital status, withholding allowances are a key determinant in the tax withholding game. 

The way allowances affect one's withholding is simple. Claiming fewer allowances increases your taxable income and results in more federal tax withholding from your paycheck, which means a larger refund (or less tax owed) when taxes are filed the following year. Claiming more allowances decreases your taxable income and results in less federal tax withholding, more net pay today, and a smaller refund (or more tax owed) when taxes are filed in April.
 
How Many Should I Claim?:

Most people simply fill out their w-4 form (the tax withholding form that all employees must complete and sign when they start a new job), answer the questions on the accompanying worksheet, and enter the number of allowances as indicated by the worksheet. This is a good, general rule to follow. However, each taxpayer's situation is unique. Some may have other sources of income that do not have tax withheld today, but on which taxes will need to be paid tomorrow. These individuals might need fewer withholding allowances in order to cover the tax liability for the year. On the flip side, most individuals have no other sources of income and can get away with claiming more withholding allowances than usual.

Is it Possible to Have too Little Federal tax Withheld?:

If you want to avoid any IRS penalties, then you need to make sure you are not under- withheld on your federal income taxes. The general rule is that you should maintain your federal withholding at a level that will cover at least 90% of your tax liability for the year. If you are not within this 90% threshold, you may have to pay a penalty. Certain exceptions do apply, but it is best to play it safe and not decrease your withholding too far.

Knowing what your tax liability will be for the current tax year isn't always an easy process. Those who have multiple sources of income, contract pay, dividends, interest, rental properties, etc. will have a more difficult time making this assessment. A tax consultant may be necessary in some instances and there are several web sites that can assist in making this calculation. 

Final Thoughts:

Withholding allowances affect everyone, yet they are something that receives little, if any, direct attention. Most of us fill out a w-4 form, answer the questions, and claim a number of allowances roughly equal to our household size. We see the federal tax withheld on our checks and we go about our life, not really thinking about the withholding and its implications on taxes and our immediate lifestyle.

Taxpayers have different motivations for selecting their withholding allowances, but a general rule to follow is that you should try to achieve a level of withholding that is very close to your actual tax liability for the year. I have coached people on this topic and the usual reaction I get is that many people like over- withholding because it means they will receive a large tax refund. This goes completely against the time value of money concept (a dollar today is more valuable than a dollar tomorrow), but some people do it anyway because they perceive excess withholding and large refunds as a form of forced savings. They then treat the refund the same way they would treat a bonus from their employer.

The problem with excess withholding is twofold. First, many do not realize this, but federal tax withholding is, in effect, an interest- free loan to the federal government. You, the taxpayer, gain nothing from excess withholding. All you will get is a larger return at tax time, and this is nothing more than a refund of money that was already yours in the first place. A tax refund is not a gift- it is your money, handed back to you, after the federal government has enjoyed its use for the previous year. The solution to the problem is simple: increase your withholding allowances to a level that results in the most net pay possible without being too low that money is owed and/or an IRS penalty results. Then, use the extra money either for investing or to pay down high interest debt. This makes better financial sense and it can add up to hundreds or even thousands of dollars over time.

Many people think the number of federal withholding allowances they claim is limited to a specific number, but this is not the case. There is no rule that says, for example, that a single person can only claim one allowance or that a married couple with one child can claim only three allowances. You can claim the number you like. However, certain individuals need to be careful. Those with multiple jobs, for example, need to exercise caution. Each job you have withholds your federal tax independent from the other job; that is, withholding is based solely on the income received at that job, irregardless of how much income is earned on the other job. Thus, those with part time jobs are likely to have little or no tax withheld, even if they claim one or zero withholding allowances. However, tax will be owed on these earnings at tax time so you must consider this before you select your withholding allowances.

Changing your withholding allowances is simple. Just go to your payroll department and ask for a w-4 form to change withholding. Make the changes, sign, and return. The changes are usually immediate (depending on the cutoff date for your company's pay cycle) and you should see results on your next paycheck. If you have any doubts or you are worried that you may have too little tax withheld, consult one of the many financial web sites that specialize in personal taxation. Many have free calculators that will help you determine your tax liability for the year and how much tax needs to be withheld per check in order to cover the bill.  

Federal income taxation has been around for nearly one hundred years, but federal tax withholding has existed for a shorter period of time- since 1943. Maximizing net pay and minimizing federal tax withholding is optimal for countless reasons. Don't let the federal government enjoy the use of your money interest free- Increase your withholding allowances and put more money in your pocket right now. A dollar today is more valuable than a dollar tomorrow, so maximize your net pay today and enjoy the fruits of your labor.

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