This was originally published on Monday, August 4, 2014, in the Pacific Daily News. Click here to subscribe to the PDN.
Question: I have been employed for some years now and have filled out a W-4 for each new job. In the past I have just filled out the form but never understood exactly what it is or how it affects my taxes. Can you help me understand it more in detail?
Answer: This is a question that I am not often asked but I believe is quite important. The allowances you claim on your W-4 affects your paycheck and how much you pay or receive at the end of the tax year.
An Employee’s Withholding Allowance Certificate, or W-4, is a form that you complete to advise your employer on how much of your income you want to have withheld for federal taxes. If you are single with a job and claim a standard deduction on your taxes then completing your W-4 is pretty straightforward. If you are eligible for other exemptions or allowances, it may get a little more complicated. All employed residents of Guam must complete a W-4 and file their taxes with the government of Guam.
The number of allowances you claim determines how much of your income will be withheld to pay taxes. The more allowances you claim will decrease the income that is held to pay taxes and vice versa. If you claim less allowances, more of your income will be withheld. The idea is to withhold an amount as close to the amount of your annual tax liability. So how do you know if you are overpaying or underpaying your taxes?
Overpaying your taxes
If you paid more than what you owe, that outstanding balance is returned to you as a tax refund. If your tax refund is rather large that means you didn’t claim enough allowances on your W-4. Many look forward to getting a large refund check, but that is not necessarily the best idea. You are getting less of your income, a smaller paycheck, and the government is essentially borrowing your income. On Guam, the other factor of overpaying is not knowing when you will actually get your refund.
Underpaying your taxes
On the other hand, if you have to pay the government at the end of the tax year, you are claiming too many allowances. This isn’t a good situation either; you may have to pay an additional penalty along with what you owe.
The number of allowances you claim doesn’t directly influence how much tax you pay. Your tax total is based solely on your income. The number of allowances does impact how much of your salary goes to taxes every payday. Think of it as installments you pay toward your total tax liability.
If you receive a tax refund you could be using the money that you loaned to the government. You could use it to pay down debt. Paying down your debt every payday will save you money by decreasing the principal balance sooner. You also could use that money to create an emergency fund. Even if you put that money in a low-interest savings account you will be earning interest that is compounding monthly.
Michael Camacho is president and chief executive officer of Personal Finance Center. He has more than 20 years of experience in retail banking and at financial institutions in Guam and Hawaii. If there is a topic you’d like Michael to cover, please email him at email@example.com and read past columns at the Money Matters blog at www.moneymattersguam.wordpress.com.