How to Properly fill out a W-4 (Paycheck Withholding Form)

Whenever you start a new job, you are required to fill out a W-4, which will instruct your employer how much to withhold from your paycheck in taxes. Taxes are withheld from your paycheck because technically, you are supposed to pay your taxes (whether it is through withholding or estimated tax payments) in a timely manner (not all at the end of the year). The W-4 gives you two ways to adjust your tax withholding: claim allowances, which reduce the taxes withheld from your paycheck, and request additional money be withheld.

Now if you are single, have only one job, do not itemize your deductions, have no other source of income, and start the job at the beginning of the year, the questionnaire on the W-4 will probably result in the correct amount of tax withheld (recall that you want to end up with a refund of a big fat zero).

However, if you don’t meet all of these conditions, your withholding will almost certainly be wrong. But there is a way to calculate the correct amount of withholding! I’ll show you how through example.

Step One: Calculate your projected tax liability

If you don’t know how to do this, look at my previous post on personal income taxes for a primer on taxes. You can get an estimate by using the previous tax year’s tax forms to create a mock return for this year’s projected income. However, this will be slightly incorrect, because the tax brackets are adjusted slightly every year for inflation. Fortunately, Forbes always puts together the information that the IRS publishes near the end of year for the next tax year (ie, in October 2014, they published the tax bracket information for the 2015 tax year). You can find 2015’s tax bracket information here.

I’ll walk you through two examples: Rachel, who is single, and Monica and Chandler, who are married filing jointly.

Rachel

  • will start her job on March 1st
  • earns $96,000 a year
  • receives paychecks are issued on a semimonthly schedule, so she will get exactly 5/6 of her annual salary this year ($80,000).
  • will finish paying her student loans this year, and pay $2600 in interest on her loans
  • will contribute $18,000, the IRS maximum for 2015, to her traditional 401k
  • lives in the state of Georgia.
  • will earn $200 in interest from her 1% savings account which holds her emergency fund of $20,000

First, she needs to calculate her AGI. In terms of income, she earns $80,000 from her job and $200 from bank interest. But, remember that traditional 401k contributions are tax deductible. Hence, she will only have $62,000 of income on her W-2. Hence, Rachel’s income that’s reported to the IRS is $62,200 (I’ve added that $200 in bank interest).

Student loan interest qualifies for an above the line tax deduction. She paid $2600 in student loan interest. However, only the first $2500 is tax deductible. She remains under the MAGI threshold for the phaseout of the student loan interest deduction, which is $65,000 for 2015 (notice how without her 401k contribution, she would have been in the phaseout range of the deduction. If she were in the phaseout range, her deduction would be reduced the more she made, until she reached $80,000 in income, where she wouldn’t qualify for the deduction at all. So without any 401k contributions, she wouldn’t qualify for any tax deduction). Hence, her AGI is $59,700.

I’m going to skip a couple steps, and just tell you that her GA tax liability will be $3092. I bring this up because state taxes are deductible from your federal taxes, but only if you itemize. Recall that it only makes sense to itemize if the sum of your itemizations is greater than your standard deduction ($6300 for Rachel). Because this is the only expense she can itemize, she does not choose to itemize her deductions on her federal taxes.

Now to calculate her taxable income: the standard deduction for 2015 is $6300, and her personal exemption is $4000. So her taxable income is $49,400.

From the table listed on Forbes, she is in the 25% bracket, and will incur a tax liability of $8143.75.

Now for Monica and Chandler

  • Both started their jobs in December of 2014, so they are getting their full annual salaries in 2015
  • Monica makes $80k
  • Chandler makes $50k
  • both max out their 401ks, resulting in a tax deduction of $36k
  • also live in Geogia
  • receive $3500 in dividends, 80% of which are qualified dividends (so $2800 are qualified dividends and $700 are not)

They are married filing jointly, so they file one tax return and get taxed as one entity. I’m not going to walk through everything step by step like the above example, but the important figures are:

  • AGI: $80k + $50k – 36K + 3.5k = $97.5k
  • Taxable income: $97,500 – 12,600 – 4000(2) = $76,900
  • Tax liability: $8242.50 [ ((76,900-0.8*3500)-18450)*0.15+1845 + 0*0.8*3500)

If that last calculation looks strange to you, reread my post on capital gains taxes. If it still doesn’t make sense, leave a comment! I’m happy to explain it.

Step two: Match your withholding to your projected tax liability

For this step, you’re actually going to want to look up IRS guidance provided to employers to properly withhold taxes from their employees’ paychecks. You can find this here. You want to jump down to the section titled How To Use the Income Tax Withholding Tables.

There are two methods that employers can use to calculate the correct amount of withholding: the wage bracket method, which involves looking up values among pages and pages of tables, or the percentage method, which just involves some math.

I suggest that you use the percentage method, because it doesn’t involve you scrolling through pages and pages of withholding tables. Also, your income may run off the table. Now granted, your employer may not use the percentage method. But the percentage method should result in tax withholding that is very close to what the wage bracket method calculates.

In the percentage method, the IRS tells you how much each allowances is worth. So for example, one allowance for single people paid semimonthly is worth $166.70 for 2015.

Then, on the next page, the tables for the percentage method are provided. You’ll notice that the amount of tax to withhold is X + Y% of excess over Z, where Y takes on values of 10,15,25,28,33,35, and 39.6 These are exactly the marginal tax brackets! Makes sense right?

So to calculate the tax withholding, you take the gross income on the paycheck, subtract the worth of all allowances claimed, and then use the table.

Let’s step through our examples.

Rachel

  • Annual salary of $96k paid semimonthly means her paychecks are for $4000 of gross income ($96k/24)
  • But she’s contributing $18k to her 401k this year. Suppose she will make her contributions evently throughout the year, so she contributes $900 to her 401k every paycheck.
  • Hence, her paycheck withholding is calculated on $3100 every paycheck
  • To start, lets say she just claims 2 allowances, because that’s what the questionnaire on the W-4 said to do (she’s single, and this is her only job). There is a section on the back of the W-4 to make adjustments to income, but for some reason such adjustments can’t be negative (the student loan interest deduction would be one such negative adjustment)
  • Each allowance is worth $166.70 for a single person paid semimonthly. She claims two, so she should look up in the semimonthly payroll period table the amount of tax that will be withheld for $2766.60. Ths results in $492.45 of tax withheld.
  • If we mutiply this tax withholding over her 20 paychecks 2015, we observe that Rachel would have $9849 in tax withheld. If she did in fact only claim two allowances, then she would be giving the IRS an interest free loan of $1705.25, because her projected tax liability is only $8143.75.
    • Why such a large disparity? Remember, tax withholding assumes you’re earning at the rate of that paycheck for the entire year! But Rachel will start work n March.

So how can she fix this? Well, she should just start with her tax liability and work backwards:

  • She should aim to have $8143.75 in tax withheld from her paychecks. Remember that underwithholding by up to $1000 is a sufficient (though not a necessary) condition to avoiding the underpayment of tax penalty, so even if she has some unexpected income, she should still be okay.
  • This means she wants to have $8143.75/20 = $407.19 withheld from her paychecks.
  • This means she’s still falling in the third line of the percentage method table ($214.80 plus 25%)
  • ($407.19 – 214.80) / 0.25 = $769.56.
  • She therefore needs $1656+769.56 = $2425.56 of income subject to tax withholding.
  • After her 401k contributions, Rachel has $3100 of income subject to tax withholding on every paycheck, before any allowances are claimed.
  • She needs to reduce that $3100 down to $2425.56 by claiming a certain number of allowances.
  • Recall that each allowance is worth $166.70, Hence, she would want to claim (3100-2425.56) / 166.70 = 4.05.
  • However, you’re only allowed to claim an integer number of allowances. You can get in between allowance amounts by filling in box 6 of the W-4 to specify an additional amount of withholding.
  • So you should always truncate the number of allowances you calculated to an integer, and add some additional withholding.
  • Rachel should therefore claim 4 allowances, which will result in 3100-4*166.70 = 2433.20 in withholding per paycheck.
  • She still needs an extra 2425.56-2433.20 = $7.64 in withholding per paycheck, which she specifies in box 6 of her W-4.

Now, your employer may not withhold exactly as you calculate because they may use the table method (or in my case, they may not update their withholding between tax years, which I find to be really strange). If that’s the case, just adjust box 6 accordingly.

And what about Monica and Chandler?

Again, I’m not going to do a step by step like the above and instead just provide the important numbers.

Monica and Chandler’s situation is more complicated: they are married filing jointly. And not only that, but they have disparate incomes.

Now it doesn’t matter if Monica pays all of their tax liability through her tax withholding, or if Chandler pays all of it, or if they both pay an equal share. The IRS taxes them as one entity. However, I’m going to calculate the tax withholding to be income proportionate, just because that seems most logical. I will treat the dividend income as earned by each of them equally.

  • Monica contributes 61.8% to their AGI ($80,000 – $18,000 + $1750) / 97500 to their AGI, and should have $5093.87 withheld from her paychecks in 2015
  • Monica should have $212.25 withheld from every paycheck
  • Monica has $2583.33 of income subject to withholding every paycheck: (80k – 18k) / 24
  • Monica should claim 3 allowances: floor( (2583.33 – (212.5 – 76.9) / 0.15 – 1127) / 166.70) and have an additional $52.53 withheld from her paycheck :  [ ( (2583.33 – (212.5 – 76.9) / 0.15 – 1127) / 166.70) – floor( (2583.33 – (212.5 – 76.9) / 0.15 – 1127) / 166.70) ] * 166.7 =
  • Chandler contributes 38.2% to their AGI, and should have $3148.63 withheld from his paychecks in 2015
  • Chandler should have $131.19 withheld from every paycheck
  • Chandler has $1333.33 of income subject to withholding every paycheck: (50k – 18k) / 24
  • In this scenario, Chandler shouldn’t claim any allowances! If he claims zero allowances, he will have (1333.33-1127)*0.15 + 76.9 = $107.85 withheld from every paycheck.
  • Chandler needs to ask to have an extra $23.34 withheld from his paychecks.

Hopefully this all made sense. If not, leave a comment!

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