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

Click here to access the 2016 tax calculator.

One of the things I do in my spare time is facilitate Dave Ramsey’s Financial Peace University. I’m also a Dave Ramsey Financial Coach. One of the situations that comes up a lot 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 calculator I created. (You can access the current version of this calculator via the link at the top of this page). This calculator 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 calculator using a current paycheck. This is to verify that the calculator is computing your data correctly. For Bob the government should be taking out $158.10 each paycheck for taxes. He can look at his paycheck to verify this.
  4. Change the withholding allowances on the worksheet to adjust your income tax so it is reduced by the amount you want. For Bob, we want to reduce our taxes by $79. So we increase our allowances until our taxes are closer to that amount. By adjusting the allowances on the calculator, we see that four would take us over our target, three would take us under. Most people would rather get a refund, so Bob should set his allowances to three. (This scenario is based on the 2015 tax year.)
  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 over $10,000. 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 the appropriate Withholding Allowance Calculator specified at the top of this page 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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6 thoughts on “Exemptions, Allowances and Deductions: How to reduce your federal tax refund

    • The Allowances is that dependents. I’m thinking of increasing my dependents at work from 1 to 3 and I get paid weekly. So this should help bring home more weekly money ??

      • Allowances are not the same as dependents, but yes increasing to 3 will bring home more money. Are you getting a tax refund now?

  1. scenario: husband decides to forge wife’s signature on tax return and refund. she finds out- she asks to see return -he takes 6 months to comply. by then he had again the current taxes- again forging/submitting without her knowledge of contents. she calls IRS and explains, requests copies of all docs, w-2, w-4’s, etc. The next year comes and goes, another, and yet another- and no taxes for her to sign. Calls IRS – yep, no taxes done since the last two forged returns. At this point, husband files for divorce and is up to no good- she suspects he is hiding all the 401ks, pension, etc-claims it is non-existent despite the proof in her hands of actual statements and check stubs. Curious as to why he would wait to file taxes when he they were expecting a refund, begins to forage around- afraid he may try to somehow throw her under the truck, files the form to protect her from any liability should he be committing fraud or owe money.
    Shortly there after, 3 letters from IRS arrive in the mail. One for each of the last three employers ( company owner died, transferred ownership and then he left for another firm) stating he was being selected for unexplained exemption change- it was not specific as to what exactly caused them to freak out- but it was drastic enough to curtail his wanting to change his w-4. As part of the 3 yr program, his employer must file a new w-4 for him as married- filing single with zero exemptions /allowances to ensure there will be tax money at end of year. Now, I understand what he most likely did, increase his allowance so as to drastically reduce his refund – the refund he was to give me 50%. He is persistent in his determination to short change the wife whats due her for her 25yrs of dedication. My question is: How much of a difference would attract such attention? Or is it because he forged my name, he was already on their radar? Or could there possibly be yet another surprise waiting for me? I am trying to stay one step ahead – trying to figure out what else he done to keep more than his fare share. Now, on the forged returns, I did not see anything odd except for the inclusion of an 401K asset of 43K, which vanished the next year and was never listed before either. Though he has at least four ira’s or 401k’s, none are listed on the last three years’ returns he now wants me to sign (now must have notorized). I cannot afford forensic anything to find money he’s hidden, lied about, etc. One more thing, he also got a bill from state for taxes owed of 6K + 2K penalty for the oldest return. This also befuddles me. Anyone out there who has had experience dealing with such a nightmare and any suggestions will be much appreciated. We are not talking millions here, probably 150K total.
    thank you

  2. How do I calculate allowances for my new job? My old job paid under 30K per year, but my new job pays over 40k. With only 4 months left in the year, I know I can give myself more allowances from my bigger paychecks because I spent 8 months with a lower paying job. But how many more?

    Additional info: I’m single, always gave myself 3 allowances for my old job, and ended up with refund of about $50 every year.