This time of the year, many employers will request from their employees updated W-4 forms (and the equivalent state form for those who live in a state with income tax). The W-4 form allows you to specify your filing status and the number of dependent exemptions to be used for figuring the amount of income tax to be withheld from your payroll. Even though the IRS provides an on-line W-4 calculator, it is generally suitable for the more simple returns and may not be appropriate in all cases since it does not take into account all income adjustments, credits, and deductions available. Be careful when completing the W-4 form because errors can create some significant financial problems.

This is where a frequent error occurs. Let’s say that you are married and have two dependents. On your tax return, you claim four exemptions. The natural thing for you to do would be to claim “married” and four exemptions on the W-4. However, for W-4 purposes, the exemption for the taxpayer and spouse are automatically built into the married rates and only two exemptions need to be claimed. The result, of course, is that the taxpayer ends up claiming more exemptions than he or she actually has, which can result in underwithholding if the standard deduction is used.

It is common practice and acceptable for taxpayers to claim additional exemptions when they have excessive withholding. The withholding tables do not account for large itemized deductions or other situations that might reduce their taxable income. It’s also quite common for taxpayers to increase their exemptions to provide more take-home pay from their payroll checks. In doing so, they are essentially borrowing tax money from the government, which they will have to repay, along with possible penalties and interest, when they file their return next year. That might seem like a good idea now, but it could lead to an unexpected tax liability at tax time. This is where a professional tax projection can more accurately establish appropriate withholding amounts.

When the IRS believes a taxpayer is not having enough tax withheld, they have a policy of issuing what is referred to as a “lock-in” letter. If it is determined that not enough tax is being withheld for an employee, a "lock-in" letter will be issued to the employer. The lock-in letter will specify the maximum number of withholding exemptions permitted for the employee. The employee's copy of the letter will explain how the employee can ask the IRS to determine the appropriate number of exemptions within a defined period of time. The employer must forward the copy to the employee or, if the employee no longer works for the employer, respond to the IRS. An employer must make the lock-in withholding rate effective 45 days after the lock-in letter date, unless told otherwise by the IRS.

Determining the appropriate number of exemptions to claim on the W-4 can be tricky if you have other substantial income on which no tax is withheld or when both spouses of a married couple are employed. The guidance of a tax professional also may be beneficial in these cases to help figure the W-4 withholding allowances and to analyze how the withholding amount may affect the need for estimated tax installment payments.

If you feel you need assistance in establishing your withholding amount, please give this office a call.

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