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When to Claim 0 on Your W-4

w4 form with pen

Since March 2020, we’ve started asking questions we never thought we would have to, like how could a 2-week quarantine turn into an 18+ month extravaganza, how the f*** does a boat get stuck in a canal, and why am I spending my days at this job when they don’t pay me enough? These questions and the new WFH norm have changed our views on remote work and the importance of spending time with the ones we love, which has led to what’s being dubbed the Great Resignation.

Americans are quitting their jobs in record numbers in search of better pay, more flexibility, and more fulfilling careers. As we begin to find new jobs that pay us more, let us attend zoom meetings with our camera off, and don’t give us the Sunday scaries, there’s one question we’ve asked before that’s going to pop back up. WTF am I supposed to claim on this W-4 tax form?

What Is a W-4?

Your W-4 is a tax document you fill out that tells your employer how much money to withhold from each paycheck to cover your income taxes. As you go through your W-4 form line by line, you can claim certain exemptions. The number of claims you make, also known as your withholding allowance, along with your salary and your pay frequency, is used by your employer to estimate your annual tax bill so they can withhold the required amount from each paycheck to cover it. 

How Much Should You Claim on Your W-4

W-4 forms are complicated, which leads many people to base their withholding allowance off of popular advice that says you should claim 0. The logic behind this is that claiming 0 on your taxes is a good idea because it will give you the largest tax return, which is true.

That’s because the lower the number of claims you make on your W-4, the larger the amount that will be withheld from each paycheck and vice versa. Since so much money is withheld from your paychecks throughout the year when you claim 0, you usually end up overpaying on your taxes. When tax season arrives, you reconcile this with the government and they pay you back all of the extra money you’ve given to them throughout the year.

If you claim more allowances on your taxes than you qualify for, or a higher number, the opposite will happen and during tax season you will owe the government the money that you didn’t pay them throughout the year. Even worse is if you pay far less than you should throughout the year, you could face additional penalties come tax time.

While you definitely don’t want to pay too little in taxes and face penalties, you also don’t want to claim 0. The extra money you pay the government all year is essentially a free loan to them. They can use your extra money to pay off their debt and invest in the country all year and then pay you back interest-free during tax season. Instead of letting the government take full advantage of your money, you could be using it to improve your financial situation instead.

What to Do With Your Extra Cash

Update your W-4 form (this can be done anytime during the year) to claim the allowances you should be claiming. No more, no less. When your new tax structure takes effect, make a note of how much additional money you’ll be getting each pay period. For example, if you used to make $2,000 every two weeks and now you make $2,100, the difference of $100 is what you need to figure out what to do with.

Build an Emergency Fund

Emergency funds are the foundation of healthy finances, so if you don’t have one, building one is where you should start. Your emergency fund will help you navigate any financial hardships without having to get yourself into more financial trouble. Since the only time you’ll use the money in your emergency fund is for, well, emergencies, it’s mostly just going to sit there, so why not earn a little extra money on it? To do that, put it into a high yield savings account. They pay you much higher interest than traditional savings accounts for doing the exact same thing. Just make sure the one you choose is FDIC insured.

Invest It

When it comes to investing, time is of the essence. As the saying goes, time in the market beats timing the market, which means you need to start investing as much as possible, as early as possible. You have several options when it comes to investing your tax savings. You can increase your 401k contribution, open a Roth IRA, or avoid the restrictions of retirement accounts altogether by using a taxable brokerage account. Just remember to automate your contributions into a Roth IRA or brokerage account (they’re already automated for 401ks) so you actually invest your tax savings instead of spending it. By investing the money you used to lend to the government for free, you can earn around 10% per year instead of 0.

Pay Off High-Interest Debt

When it comes to whether you should pay off debt or invest your extra money, investing is almost always the best option. The exception is when you have high-interest debt. 

The average annual return on the stock market is 10%, so if you have any debt with an interest rate higher than that, you should pay that debt off first. Most credit cards charge much higher interest than 10%, so if you have any credit cards that aren’t fully paid off, prioritize paying those off before investing.

Save for Other Things

Need a new car, want to go on a vacation, or simply want to have more money to spend on Christmas gifts this year? Start a sinking fund for any large purchases you have coming up. 

To set up your sinking fund, figure out the total amount of money you’ll need and when you’ll need it. Then determine how frequently you’ll contribute to your sinking fund. Will it be monthly, every 2 weeks when you get paid, or some other interval. Then, take the total dollar amount and divide it by the number of contributions you’ll make until the day you’ll use the money. For example, if you need $1,000 for a vacation in 1 year and you’re contributing to your sinking fund monthly, that’s $1,000/12 months = $83 monthly contribution to your sinking fund. High yield savings accounts are also great places for sinking funds and they’ll help you earn a little extra money towards your goal.

So when should you claim 0 on your W-4? Never. Doing that just ties up money you could be using to build your financial foundation, earn more money by investing, pay off high-interest debt, or save for other fun things. So when you get that new job that’s more fulfilling and actually pays you what you’re worth, start practicing some smarter financial habits alongside starting your new job. The first of which should be claiming what you qualify for on your W-4.

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