Exemptions, Allowances and Deductions: How to reduce your federal tax refund

Update: I've created a new calculator for 2014.

A little change of pace. Let's talk taxes.

One of the things I do in my spare time is facilitate Dave Ramsey's Financial Peace University. I'm also one of Dave's Certified Counselors. One of the situations that comes up a lot (especially this time of year) is people getting large tax refunds. They don't understand why large tax refunds are bad and they don't understand how to use the allowances or exemptions on their W-4 (PDF) to reduce their refunds. I'd like to try to clear things up. Note that I am not a tax professional or an accountant, and your situation may be fact dependent. If you need specific advice, your should go to a professional.

Why tax refunds are bad

Just to be clear, tax refunds are a no interest loan to the government. Every dollar you get in a tax refund is a dollar that you could have taken home at some point during the year. I see people struggling to make their bills month to month, but getting large refunds. They don't realize that they could be bringing that money home in their paycheck instead of waiting to get it in April by changing their allowances. This would help a lot of their struggle.

What are allowances?

Before we talk about reducing your refund, we need to clear up the concept of allowances vs. exemptions vs. deductions, since this is what causes much of the confusion. The W-4 form (PDF) allows you to specify your allowances (sometimes called exemptions). It also provides a some worksheets to help you try to figure out your allowances. Most people rely on these worksheets to figure out their allowances without looking at their overall tax situation. These worksheet attempts to guess what deductions you will have on your taxes so that it can then compute how many allowances you should take. It might work if you are filing a 1040EZ (PDF) or have a simple tax return, but for most people it simply doesn't cut it. So how do I determine my allowances? We'll go into that in a minute, but let's again define our terms. Allowances or exemptions are about the amount of money that is taken out of your paycheck during the year. Deductions are about things you deduct from your income when you do your taxes.

So how do I determine my allowances?

Generally it is pretty difficult to predict your taxes for the following year. So what we are going to do is attempt to use the refund you got this year to modify your allowances so you get less of a refund next year. We're going to do that using a worksheet I created. This worksheet will allow you adjust withholding allowances interactively to see how they will impact your take home pay. Let's take a specific example (Note I completely made these numbers up.)

Bob is paid weekly. He makes $1000 dollars a week. He does not contribute to his 401(k) and he does not have any health care expenses taken out of his paycheck. He is single and is not claiming any allowances, so the government is taking out the maximum amount of income tax. He did his taxes and he discovered that he got a $3000 refund. He wants to know how he can take that home instead of giving it to the government. Here are the steps to follow:

  1. Figure out how many paychecks you have left this year. Bob is did his taxes on April 15, so he has approximately 38 (52-14) paychecks left this year.
  2. Divide your refund by the number of paychecks left in the year to get the additional amount you want to take home each paycheck. For Bob, this is about $79 (3000/38).
  3. Fill out the information in the worksheet using a current paycheck. This is to verify that the worksheet is computing your data correctly. For Bob the government should be taking out $169.70 each paycheck for taxes. He can look at his paycheck to verify this.
  4. Change the withholding allowances on the worksheet to adjust your take home pay so that it is increased by the amount you want. For Bob, our target is $832 ($753+$79). By adjusting the allowances on the spreadsheet, we see that five would take us over our target, four would take us under. Most people would rather get a refund, so Bob should set his allowances to four.
  5. Fill out a new W-4 form (PDF) and submit it to your payroll department. Some companies might provide an online way to do this.

Note that you can also use this method to take home money during the year if you know FOR SURE you are going to be getting a tax credit. For instance, if you adopt a child, you get a tax credit of $10,960. Instead of waiting to get that as a refund, you can simply adjust your allowances so that you get that money during the year. Only do this if you KNOW the adoption will be finalizing before the end of the year!

Some people might find that because they give a lot to charity or have a lot of deductions, that they might need to set their allowances over ten. When you try to do this, your employer might say something scary about needing to notify the IRS if you go above ten. Don't worry about it. It's just a formality. There is nothing wrong with going above ten allowances as long as you are not doing this to try to avoid paying taxes during the year. When I adopted my children, my allowances went way over ten. It's not a big deal. The important thing here is not to use this method to take home all your money and then pay a lot at tax time. If you do this, the IRS will start requiring you to pay quarterly taxes. Our only goal is to reduce our refund.

Finally, if you know you are going to be paying capital gains or some other extra tax, this computation might not work for you. So be careful.

So to summarize. You don't want a big refund. Take your money home during the year. Use my 2008 Withholding Allowance Calculator to figure out how to adjust your allowances.

Nerd Note: The amount of each withholding allowance is based on your marital status and your pay cycle. It is also dependent on the specific amount of your pay (the percentage changes as your pay goes up). If you are curious how this works, you can read IRS Publication 15 or just read my JavaScript code.

Please note: I reserve the right to delete comments that are offensive or off-topic.

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8 thoughts on “Exemptions, Allowances and Deductions: How to reduce your federal tax refund

  1. That calculator is very helpful - thank you! It was much easier to use than the IRS's version, and the resulting computations were almost spot-on. To increase the accuracy of the results, I put my state tax withholdings into the after tax deduction column.

  2. My wife and I both work and we got a large refund for 2013. ($2700).
    Does your calculator for 2008 work for 2014 tax purposes?

    Thank you and I've been following Dave Ramsey for years.

  3. I also recently got married and my wife is going to start a new job soon. So using "1" allowance on each of our W4s suffice? Eventually I want to try and come out even (no returns and no tax liability), but I figured starting with an allowance of 1 would help me land on safe side.
    When we file for returns, I was planning to fill in "2" for exemptions. I also was planning to file Married jointly, would she have to fill out a separate 1040 and fill out exemptions also?

    Any suggestions as to if I am headed in the right direction? Much appreciate the help.

    P.S. The calculator was spot on! Thank you!

    • If you are married filing jointly, you only fill out one tax return. All your income is combined on one return including your deductions (remember, exemptions is only a term on your W-4).

      As far as using 1 for your exemptions, I would probably use at least 2 to start out. 1 will very likely result in a refund (depending on your other deductions like a mortgage or charitable giving). Your wife can start with 1, though.

      It's quite hard to predict things the beginning of a job. The key for you guys is after you file your taxes next year, if you get a refund, divide it by 12 and run the calculator and see how you need to adjust things.

      • Thank you Mike. That certainly helps. That brings up another question regarding tax bracket.
        I started my current job in April and my wife will start her new job Nov 1st. So for 2014 tax purposes, are we taxed on the total pre-tax income amount or the YTD that we get our checks for? I realize it's a stupid question but I just wanted to clarify. Because we are already taxed on the income, so taxing twice doesn't make any sense.