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Let’s cover a few basics. What is the number of allowances that you currently have on your W-4? If you do not know, go find out now (look at your pay stub and/or look online). Did you get a tax refund or did you owe money on last years return? Do you expect your income to be similar to last year? Will it go up or will it go down?
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If you have 0 on your W-4 that means you are having the maximum amount of taxes withheld from your paycheck. As you go up in numbers you will have less money taken out of the paycheck (federal and state). This has nothing to do with how many people you have in your family or how many exemptions you have on your tax return. You could have 3 people in your family and because you have multiple tax deductions and/or credits, you may have 6 allowances on your W-4. Your allowances should reflect how many exemptions, deductions and credits you have.
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The goal here is very simple. At a bare minimum you should strive to break even come tax time. If you want to really make the most of the situation, the goal would be to owe as much as possible (less than $1000 or 100% of last years taxes) without paying any penalties. This means you would make a change on your W-4 and raise your allowances to the highest number that would keep you under those two barometers. Do not let anyone tell you how many allowances you should have on your W-4. Only you know your tax situation and only you should be deciding this issue.
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Go here to access the IRS withholding calculator. This will provide you with the link where you can put in your numbers and the calculation will do the rest.
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Raising your allowances will increase your monthly paycheck. Let’s say you raise your allowances by 4 and maybe you start receiving an extra $300 in each monthly paycheck (federal and state withholding taxes are reduced, FICA will not be affected because that tax is taken out from your gross pay no matter how many allowances you have). So what do you do with the extra money?
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Do not spend this money! This defeats the purpose of raising your allowances and it will make you more poor because there will be no big refund coming next spring. Here is a list of places where this newfound money could go. I would recommend you go down this list as you prioritize where the money could best be used.
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Pay off debt (credit cards, cars loans, student loans, etc.)
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Fund your emergency account (no spending until this is done)
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Raise your 401K contributions (your future will thank you)
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Open up a Roth IRA (see ROTH IRA on this website)