I read about allowances and I have to talk to an accountant about updating my W-4 to 2 allowances. Right now its at 0...However, i'm not sure i understand what this means. Can you please explain this in simple language? The only thing I understand is that if noone claims me I can claim myself as a dependent (1 allowance), and if I only work one job (another allowance)..therefore I put 2 allowances. What does this do to my taxes on a pay check to paychek basis and at the end of the year basis. Thanks in advance.
Simple form: An allowance decreases the amount of tax withheld each check. In more complex terms, an allowance is a way for you and the IRS to *anticipate* (forward looking prediction) what level of deductions you will be taking at the end of the year. Higher allowances are associated with family, children, self employment, etc .. because people in these situations will be taking more deductions (reduction of taxable income) at the end of the year..
Per the IRS .. you can do this 2 ways.
1. Set your allowances based on the employer provided worksheet (like you just talked about .. dependency status, # of jobs, family size, etc) .. see second post for more info on the flaws of this method.
2. Calculate your estimated taxes owed using the IRS calculator (or any calculator) and set allowances based on how much tax you anticipate owing... each additional allowance reduces the amount of taxes taken out of your biweekly check. 0 allowances means the IRS withholds basically the maximum possible tax that you could conceivably owe.
Here is a simple rule of thumb. more allowances = you keep more of your paycheck.
---Setting too many allowances .. and you will owe at the end of the year .. once you get over a certain amount , you can get penalized , for inaccurate withholding , this happens when you owe the IRS something like 5-10k at the end of the year.
---Setting too few allowances .. not illegal but you will get screwed because you are basically giving the irs a year long loan until they give it back and you get a giant tax return.
Because of the nature of first year pharmacist work (ie variable hours, graduate intern pay, floating, deductible expenses (transportation, licensing, mileage, depending on job status) , the standard recommended allowances typically will screw you , and you will get a huge tax return at the end of the year (goal is to keep as much money as you can out of each check) .. So during your early years, you will want to set allowances based on your calculated yearly earnings. Typically the amount of tax withheld is based on a projected income from 1 year of biweekly paychecks.. as you probably know, this is likely inaccurate.
Use the IRS withholding tool. It willl help you see what is being withheld versus what you will likely owe on a yearly basis. You want to set your allowances so that IRS withholds just enough so that you dont owe at the end of the year, but not so much that you are losing money on a weekly basis only to have it paid back to you at the end of the financial year.
http://www.irs.gov/Individuals/IRS-Withholding-Calculator
You can set any # of allowances legally as long as you dont owe the IRS over a certain amount at the end of the year. It is a common misconception that you need to use the amount of allowances on the worksheet.
Basics: Calculate your yearly tax owed (using irs calculator or tax tables, or any method).. Divide it by the number of paychecks you expect (not 12x2 .. because in a given 52 week year there are going to be an extra check or two). Then set your allowances so that this amount is withheld each check.
Because you will be estimating your taxes owed due to the fact that your hours or pay rate may change (ie floating, overtime, bonuses, etc) .. you may have to change your allowances occasionally , if you are following the most aggressive strategy. You really dont want to owe the IRS at the end of the year. But, the more allownces you take, the more money you take home each month.
Edit: sidenote/tidbit. Allowances worksheets are designed to help working class people make sure that they can achieve financial stability and never owe tax at the end of the year .. also it allows them to basically 'save' money by storing it in the IRS coffers to be received as a 'bonus' check at the end of the tax year. This helps people feel good by getting a 'tax refund' .. and helps make sure they are never screwed by the govt and cause them financial ruin. Obviously this is not super applicable to high income earning people who have financial knowledge.
Edit #2. You dont need an accountant to do this. This is personal finance 101. You will be ripped off by paying an accountant to help you set your allowances, unless you are in a very particular and unique situation, such as having an unusual marriage/family tax situation, being a small business owner, working as an independent contractor, receiving investment income, etc.
