Welcome to the official blog of Brittany Lanphier, managing partner of Lanphier Accounting LLP based in Denver, Colorado!
Any tax guidance in this blog is intended for informational purposes only and is not guidance on which Lanphier Accounting LLP intends for you to rely. All tax issues specific to your business or family are largely facts-and-circumstances based and you should consult your tax advisor (or Brittany directly) to discuss how this might relate to you.
Last week was an exciting and busy week for Lanphier Accounting LLP. Most notably, I finally got my home office organized and all of my client papers filed, which makes me feel as though I have some semblance of my sanity back after the payroll tax rush of January. Okay, maybe that wasn’t the most notable experience of the week, but it was definitely my greatest personal accomplishment since my last posting.
On Wednesday, Dennis and I had the opportunity to participate in Career Day at the Pinnacle Charter School in Federal Heights, Colorado. It was a great event and we had a lot of fun talking with all of the students about careers in accounting and law.
I especially enjoyed talking to the girls about what a great degree option accounting can be for women, as it gives you so much flexibility in career paths. One of the reasons that I chose accounting was that, while I didn’t know what my life would look like 5, 10, or 20 years after graduation, I knew I would have opportunities to make accounting fit into whatever life I was blessed to have. As an accountant, you can be anything from a CFO of a Fortune 500 company to a mom who runs a small practice out of her home…as well as any number of options in between.
Not to brag, but Dennis and I definitely had the most popular table at the event, which had much less to do with us than with the fact that we were handing out free pens. If there is anything that I learned from my career day experiences in high school and college it’s to not even bother showing up unless you have free stuff at your table…especially if you are an accountant and lawyer going up against firefighters, astronauts, and athletes.
A big thank you to Steve Rydin at True Summit Promotions who got these great ball point pens done for us super fast and at a great price. We were extremely pleased with how the turned out, so get in touch with Steve for any promotional items your business may need. Aside from using the pens to attract kids to our table so we didn’t feel like losers, we thought it was a great way to get something in their hands that they could take home and leave on the kitchen table for Mom and Dad to find (and potentially check out our website).
Our other big event this week was our official ribbon-cutting with the Metro North Chamber of Commerce. We had a great turnout and are so appreciative of everyone from the Chamber that made the effort to come out. We had about 30 people in attendance, making great connections with financial advisors, realtors, bankers and many more in the Westminster area. We look forward to building on these business relationships in the weeks and months to come.
For this week’s tax segment, I am going to crack the mysterious code of Form W-4. In my experience, about 2% of employers and employees truly understand how this form works and how it affects the amount of federal withholding taken out of each employee’s paycheck. I’ll admit that I used to be as mystified by it as anyone, so I feel this will be helpful for both employers and employees alike.
While employers shouldn’t put themselves in the position of advising their new employees on what to put down on their W-4, having a proper understanding of the form will help you at least explain the fundamentals or to identify potential errors in a completed form.
What is Form W-4?
Form W-4 is the form that all new employees fill out upon employment to ensure the “proper” federal income tax is withheld from each paycheck. The tricky part is that federal income tax is not simply a function of your gross wages, and any two people earning the exact same salary may have vastly different taxable income at the end of the year based on their number of dependents, whether they own a home, and any number of other deductions they may be reporting.
The goal of Form W-4 is to give you as much money in your paycheck as possible, while still paying enough in federal withholding that you won’t owe anything in the following April. If you are getting tax refunds of $3,000 to $5,000 each year, you are having way to much withheld from your paychecks. And while its feels nice to get that money back at the end of the year, you have essentially just given the government an interest-free loan for 12-15 months. Wouldn’t you rather have that today, so at the very least you could earn a little interest on it in a savings account?
Given that, it is an even bigger bummer if you end up having to pay taxes at the end of the year because you didn’t withhold enough. If you under-withheld by a bunch, you could even be subject to penalties for failure to deposit taxes. So we want to use Form W-4 to have just enough but not too much withheld from your paychecks. Obviously, since its impossible to predict your taxable income perfectly, its better to err on the side of conservatism and withhold a little too much rather than too little.
What is an Allowance?
The first time anyone looks at a W-4 their obvious question is “What the heck is an allowance?”.
An allowance is a specified dollar amount that is deducted from your gross wages before calculating the tax to withhold. It is intended to “allow” for certain deductions you will be entitled to take against your income on your tax return. So the first rule of thumb is that more allowances results in less federal withholding results in more money in your net paycheck.
What is the allowance amount? It varies based how often you are paid. The IRS publishes these amounts every year in Circular E (also known as IRS Publication 15). So for 2010, if you are paid twice a month (semi-monthly) each allowance is $152.08. Likewise, if you are paid monthly, each allowance is $304.17 ($152.08 x 2). So you can see that while the allowance amounts are different, they result in the exact same withholding over the course of a year:
1 semi-monthly withholding ($152.08) x 24 pay periods = $3,650
1 monthly withholding ($304.17) x 12 pay periods = $3,650
(a few cents difference due to rounding)
Miraculously (not really), $3,650 is the amount of the personal and dependency exemption for 2009 and 2010. So you can see that each allowance is intended to equal one of the exemptions you will take on your return for your children, your spouse, and yourself.
The thing to understand is that allowances are not necessarily limited to the number of kids you have. If you have any additional deductions that you anticipate will exceed $3,650 for the year, you should claim an additional allowance. For instance, if you own a home for which you will pay at least $3,650 in mortgage interest annually, you should claim one more allowance on your W-4 because you will have an additional $3,650 in deductions on your tax return.
Does it Matter if I’m Married?
What many employees fail to realize is that they must coordinate the number of allowances they are claiming with their spouse if they are married and both working. If you and your spouse have 2 children and both work, and you each claim 4 allowances (one for you, your spouse, and your kids) on your separate W-4s, you are basically assuming $29,200 in allowances ($3,650 x 4 allowances x 2 W-4s). However, you will really only be entitled to $14,600 ($3,650 x 4) in exemptions on your joint tax return.
Therefore, you and your spouse should fill out one W-4 together, determining the total number of allowances you should claim. Then, it is generally recommended that the spouse with the higher earnings claim all of the allowances on their W-4 with the other spouse claiming zero. In most cases, this will result in more accurate withholding than splitting the allowances between W-4s.
How is Federal Withholding Calculated?
The IRS provides tables for determining withholding in Circular E. While there are two methods for calculating withholding, both provide roughly the same result, so I will only be covering “the percentage method” here.
There are tables for each pay frequency (monthly, semi-monthly, bi-weekly, etc.), and each table has one side for single persons and one side for married persons. These separate tables reflect the different tax brackets for married and single individuals, so make sure you are using the right table.
Let’s say you are a married individual who makes $60,000 per year. You have two kids and a house for which mortgage interest will exceed $3,650 for the year. Your spouse earns less than you and therefore claims zero allowances on their W-4, so you claim 5 allowances (1 for you, 1 for your spouse, 2 for your kids, and 1 for your house). Your employer pays you once every month, so each month your gross wages are $5,000.
First we determine the amount of those wages subject to withholding using your allowances.
– Total allowances = 5 allowances x $304.17 (monthly allowance) = $1,521
– Wages subject to withholding = $5,000 – $1,521 = $3,479
Now, if we go to the table on page 39 of Circular E (posted above), it tells us that the first $1,146 of wages are not subject to withholding. Great! The next $896 in wages are subject to 10% withholding, therefore the maximum withholding on your monthly wages up to $2,042 ($1,146 + $896) is $89.60 ($896 x 10%).
How much in wages is left to determine withholding on?
– Remaining taxable wages = $3,479 – $2,042 = $1,437
These wages are subject to a 15% tax, therefore $215.55 withholding is assessed on these wages in excess of $2,042 per month. This brings your total withholding to $305.15 ($215.55 + $89.60).
On the other hand, if you had claimed zero allowances instead of five, your entire $5,000 would have been subject to withholding. This would have resulted in $533.30 being withheld from your paycheck.
By claiming those allowances, you received more than $200 more in that single paycheck. Over the course of the year, this would result in an extra $2,400 in your pocket. You wouldn’t be loaning that money to the government for several months before having the opportunity to spend it on your family.
So, sufficiently confused now? At the very least, you are probably extremely glad that your employer calculates this for you…or if you are an employer, that your payroll software or CPA calculates it for you. It is, no doubt, very confusing with a lot of moving parts.
Even though you will hopefully never have to make these calculations yourself, knowing the fundamentals of how it is calculated should provide some insight into how you should approach Form W-4. You could also potentially determine the impact that changing your W-4 status would have on your net paycheck.
If you are still wanting some guidance on determining how many allowances to claim, the IRS has a withholding calculator available on their website that will help you determine how many allowances you should be claiming on Form W-4.
Additionally, we have a great interactive net paycheck calculator on our website, where you can see the impact on your paycheck of changing your W-4 status.
Thanks again to everyone for checking in and reading up on Lanphier Accounting LLP. I welcome any comments or questions on the information provided in this blog, as well as any ideas for tax topics to cover in future posts.
Best to everyone!
Lanphier Accounting LLP
600 17th St., Suite 2800 South
Denver, CO 80202