How many allowances should you claim?
Do you remember filling out your W-4 at your first job and having no clue how many allowances to claim? I do. I claimed zero under the advice I would receive a huge tax return which I did, but realized, I was giving the government a tax-free loan (If you’re confused by that statement, don’t worry I will clarify it later in this article).
Now, don’t get me wrong, that tax return at the end of the year was awesome. I always felt rich and throughout the years would use it to pay off debt, buy a car, save it, and invest it. I always thought of it as an annual bonus.
But that begs the question – how many allowances should you claim? Receive a “bonus” each year or receive it each month for immediate use. I do not intend to persuade you to claim allowances; however, I want you to be aware of the financial concepts that would suggest doing so.
One financial concept is opportunity cost, which is the cost of a missed opportunity. The Oxford Dictionary defines it as “the loss of other alternatives when one alternative is chosen.” By choosing to claim zero or minimal allowances, you’re losing the ability to use that money now. If you choose to claim the max allowances or a few, you’re gaining the ability to use the money now, but losing the opportunity to receive a larger return later.
Both have their advantages. Some people prefer the government to hold their money so they will receive a larger return (also, some individuals have money behaviors that would cause them to spend it unnecessarily). For others, they would love to receive more money each paycheck to spend right away, invest, or save. Which leads us to the next financial concept, time value of money.
Time Value of Money
The time value of money concept implies that money is worth more today than in the future because of it’s potential to be invested and earn interest. It‘s one of the core principles of finance and for good reason. Money is worth more now than later because of opportunity cost, inflation, and interest.
With that in mind, claiming more allowances allows you to save, invest, or spend money now instead of waiting. Money saved or invested earns interest and therefore, is worth more. Money spent has more value now than in the future because of inflation and increased cost-of-living expenses.
So back to my point earlier about giving the government a tax-free loan. By claiming zero or minimal allowances, I am not providing myself the opportunity to use cash that is worth more now than in the future. I am allowing the government to use it, only giving it back at the end of the year when it is worth less. That money has been sitting in the government’s account earning interest for them and not for me. Seems kind of messed up, right?
Your W-4 tells your employer how much money to withhold from your paycheck and send it to the federal government on your behalf throughout the year (as of 2020, the W-4 form has changed. Instead of allowances, you fill out 5 sections: (1) Personal information, (2) Multiple Jobs or Spouse Works, (3) Claim Dependents, (4) Other Adjustments (optional) and (5) Signature).
The more allowances you claim, the less federal income tax your employer withholds from your paycheck (aka the bigger your take-home pay). The fewer allowances you claim, the more federal income tax your employer withholds from your paycheck (aka the smaller your take-home pay).
Instinct would say you want the bigger check, but the amount withheld goes towards your annual taxes due at the end of the year. If you don’t have enough withheld, you’ll owe Uncle Sam at tax time. If you have too much withheld, you’ll be due a refund. The key is finding the right balance.
Calculating your Allowances
Luckily, the IRS provides a FREE fantastic Tax Estimator Tool to find that right balance.
The IRS encourages everyone to use the Tax Withholding Estimator to perform a “paycheck checkup.” This will help you make sure you have the right amount of tax withheld from your paycheck.
There are several reasons to check your withholding:
- Checking your withholding can help protect against having too little tax withheld and facing an unexpected tax bill or penalty at tax time next year.
- At the same time, you may prefer to have less tax withheld up front, so you receive more in your paychecks and get a smaller refund at tax time.
Calculating your W-4 allowances is a balancing act — the 2020 W-4 should make it easier.
Remember, the fewer allowances you claim, the more tax will be withheld from your paycheck. That probably means overpaying your taxes throughout the year, equating to smaller paychecks. But, you’ll most likely get a refund after filing your tax return. However, a refund is just Uncle Sam repaying the interest-free loan you gave the federal government throughout the tax year.
If you claim too many allowances, you might end up owing tax which isn’t ideal. So, be careful how many allowances you claim, and do not falsify any – it could lead to penalties and jail time.
Taxes are complicated, but luckily, some professionals can assist such as a CPA. If you have any qualms or confusion about your taxes, it might be better to hire a professional to make sure you do it right. Happy tax season!