Graduating? Calculate Your Tax Withholding

This article is part of a series called Graduating? which focuses on personal finance advice for fresh college grads.

Ewwwwwww… taxes! Too bad for those of us living in the U.S. of A. – we have to hand over a portion of our paycheck to Uncle Sam. But when Human Resources at your new job hands you a W4 form, do you know what to do with it?

W4 – That Tax Form

A W4 form is simply a way of indicating how much of your paycheck you’d like your employer to take out for taxes. Of course, your ideal answer is “NONE!” But that won’t do you much good – the government will take their due when you file your tax return next year, and you’ll be charged a penalty for not withholding enough. Say it with me: “Paying a penalty sucks.”

So, since you don’t want to underpay, you have two options left: overpay (and get a refund check when you file), or pay just the right amount.

Personal finance experts say that you should go for paying just the right amount, because if you overpay, you’re giving an interest-free loan to the government. That makes sense, but I disagree. I think there are several reasons a fresh college grad should overpay:

1. Getting a tax refund is better than having to pay. It’s a greater hardship for most of us to have to pay something we weren’t expecting, than to give a small interest-free loan to the government. (Why you should be happy to get a tax refund, not guilty)
2. Many of us are involved with freelance work or entrepreneurship in addition to a regular job. Since taxes usually are not withheld for these activities, it’s a good idea to have extra withheld from our day jobs to make up for it.
3. You won’t really have an idea of whether you’re withholding too much, or not enough, until you’ve done it for a few years and seen what happens when you file your taxes. Best to over-withhold the first few years of your career, and then adjust it down.
4. If you’re smart, you can use a tax refund as an automatic savings. When you get the check, put it straight into a high yield savings account or a retirement account.

How to Calculate Your Withholding

When you’re handed a W4 at your new place of employment, the standard reaction is to look at Human Resources and say “Uh, what do I put down?” And then you’ll receive a wishy-washy answer that doesn’t help at all, like “Well, that depends on what you want.”

Instead, go in prepared. The IRS has a tax withholding calculator to figure out how many “exemptions” you want to claim on your W4. You can adjust the number it gives you up or down – a lower number means they will withhold MORE, and a higher number means they will withhold LESS.

Part-Year Method

One more thing that’s mucho important if you’re starting a job in the middle of the year. The W4 doesn’t take into account how much of the year you’ll be working a certain job. Say you start a job with a $45,000/year salary. You employer will end up withholding an amount relative to a $45,000 salary, but you’ll only be making about $22,500 that year, since you started in the middle. That means your employer will take out double what they should!

The best thing to do in this case is to get your employer to agree to withholding using the part-year method. The instructions for requesting part-year withholding (from the IRS website):

How to apply for the part-year method.   You must ask in writing that your employer use this method. The request must state all three of the following.

• The date of your last day of work for any prior employer during the current calendar year.

• That you do not expect to be employed more than 245 days during the current calendar year.

• That you use the calendar year as your tax year.

Sounds like a pain, but just type up a quick request, sign it, and take it into work with you.

Taxes really aren’t so bad, and if you over-withhold, you get to jump in the air and yell “YIPPEE!” when the refund check comes! (What? I know I’m not the only one who does that!)

Photo by Paul Keleher