How to Fill Out That W-4 Form

When Treasury Secretary James A. Baker III asked the Internal Revenue Service recently to study simplifying the new W-4 withholding form, taxpayers jumped for joy. They hoped that they could avoid the complicated form and instead wait for a new one.

But a new form may not come out for months, if ever, IRS and Treasury officials say. And if it does, it still may be the same length, which is twice as long as the previous one. The only changes may be clearer instructions.

Thus, officials advise, taxpayers should go ahead and complete the current form. To delay doing so, Baker said, may subject a taxpayer to “a lot of unpleasant surprises down the road,” such as a large tax payment or penalties that could run into the hundreds of dollars.

To help you complete the new W-4, here are some explanations, shortcuts and tips:

QUESTION: Why must I complete the new form?

ANSWER: The new form was created to reflect sweeping changes stemming from the Tax Reform Act of 1986. Your withholding allowances under the old laws may not accurately reflect what you are entitled to now. Thus, if you do not complete the form, you may be having too little or too much tax withheld.

If you have too much withheld, under normal circumstances you will get a tax refund next year. If you have too little withheld, you may get socked with a big tax payment come April, 1988. Also, you could be charged an interest penalty if withholdings--plus quarterly estimated tax payments--don’t equal at least 90% of this year’s liability or 100% of last year’s liability.

You also could be hit with a penalty of $500 if you knowingly file a false W-4 that results in little or no withholding even though you know you should have large amounts withheld. You also could face criminal penalties if you willfully give false or fraudulent information.

Q: What are withholding allowances, and how do they make a difference?

A: The more allowances you can legitimately take, the less tax your employer will withhold, and thus, the more take-home pay you will receive. On 1987 income, each allowance you claim exempts $1,900 a year in income from withholding. Thus, having too many or too few allowances could add up to a lot of money owed to the government, or owed back to you, depending on your income.

Q: What is different and difficult about the new form?

A: The actual half-page withholding certificate that you turn in to your employer--where you list the number of allowances you wish to take--is basically the same as on the old form. But the new form adds a work sheet on Page 3, work sheet instructions on Page 2 and tables on Page 4. Those four pages give the new form twice the bulk of the old version.

The IRS added this paper work in an effort to get your withholding to more accurately reflect the actual amount of tax you will eventually owe. For example, if you have many itemized deductions, the work sheet helps you accurately account for them so you can add to your allowances.

But taxpayers are finding the work sheet difficult, particularly where it asks them to calculate adjustments to income and itemized deductions, accountants say. These calculations generally require familiarity with the new tax law and are difficult to estimate for the whole year with any precision.

Complaints also focus on the part of the work sheet asking you to account for non-wage income and the income of a working spouse. Previously, you did this in your head and subtracted those income amounts from your deductions to arrive at the correct withholding allowances.

Some taxpayers undoubtedly are confused because they have not filled out a W-4 in a long time or because they do not complete their own tax returns each year, accountants say. Other taxpayers are merely intimidated by the length of the form, although if they read it carefully, they may not find it quite as difficult or imposing, said Gretchen L. Pearson, a manager in the tax department of the Los Angeles office of the accounting firm of Ernst & Whinney.

“People look at the four pages and are overwhelmed by its length without reading through the form line by line,” Pearson said. Many taxpayers, particularly those who do not itemize and who use the simplified 1040A or 1040EZ forms for their tax returns, will not need to complete the most difficult parts of the work sheet, she said.

Q: What if I miss the deadline?

A: The deadline for completing the new W-4 is Oct. 1. If you miss it, there is no criminal penalty. However, your employer will complete the form for you by giving you only one allowance if you are unmarried and only two if you are married. That could easily result in too much or too little withheld.

Q: What is non-wage income, and why is it important?

A: Non-wage income generally includes any income not directly subject to withholding by an employer. That includes interest, dividends, profit from rental income, capital gains, certain annuity income, the taxable portion of Social Security benefits, unemployment compensation, farm or business income, income from being an independent contractor, prizes and gambling winnings.

The IRS wants you to account for non-wage income on the W-4 because you will eventually be taxed on it anyway, and thus, it should be included in your withholding. If you have large amounts of non-wage income, you must complete Lines Q through T on the work sheet or risk having too little tax withheld. Even so, if you have unusually high amounts of non-wage income, you may have to make quarterly estimated tax payments or have your employer withhold additional tax even if you claim no withholding allowances. Failure to do so could result in a penalty for underpayment of tax.

Q: Can I skip the work sheet?

A: Not really. But taxpayers with simple tax situations may need to fill out only the first five lines of the work sheet--Lines A to E. This is the easiest part of the work sheet, asking you only to compute allowances based on whether you are married, have dependents and more than one job.

Q: How will I know if I just need to do the first five lines of the work sheet?

A: You need to complete the first five lines only if you meet all of these requirements: You are either single or married to a spouse who does not work; you have income from only one job at a time; you do not have large amounts of non-wage income; you have no adjustments to income, such as alimony paid or contributions to individual retirement accounts, and you do not itemize deductions.

The IRS estimates that about 60% of the nation’s taxpayers do not itemize. Most probably can stop after the first five lines.

However, there still are some lines that even non-itemizers or low-income people should still complete. For example, you should still complete Line K if you expect to claim the earned income credit or other tax credits. And you should complete Line J if you are age 65 or older, or blind, and qualify for the age or blindness deduction. Completing these lines will give you more allowances and thus reduce withholding of money you are entitled to keep.

Q: Are there any shortcuts for itemizers?

A: Although the IRS recommends that itemizers complete most of the work sheet, you may skip all or part of it. But that could result in too much or too little tax withheld.

But if you do not have a lot of non-wage income and don’t mind having too much money withheld and getting a tax refund later, some of these shortcuts may be for you. Here are some of the more common shortcuts:

- Skip the work sheet and simply claim one allowance if you are single or married with a working spouse, or two allowances if you are married with a non-working spouse.

“If you claim only one or two allowances, chances are you are OK” and will not have to face a large tax payment or penalty for having too little tax withheld, IRS spokesman Robert Giannangeli said.

However, if you itemize, you probably are entitled to more allowances, he said. Also, you could miss out on the special allowance granted in Line B. It gives you a special allowance if you are single and have only one job; if you are married, have only one job and your spouse does not work, or if wages earned by you on a second job or earned by your spouse (or both) are $2,500 or less.

- Skip the work sheet and just report the same number of allowances that you claimed last year. This normally would put you at risk of not having enough withheld. But this method could work if you expect to receive a large refund from last year’s taxes. Receipt of a refund means that you were overwithheld last year. Thus, claiming the same number of allowances could make up for being overwithheld last year.

Nonetheless, such a strategy could be risky if you claimed a lot of allowances last year--say, five or more, IRS spokesman Giannangeli said. That is because of lot of deductions last year, such as individual retirement accounts and credit card interest, have been reduced this year. So some allowances you claimed last year may not be available to you this year.

Thus, if you had more than five allowances last year, you could simply take about half of those allowances this year. Unless your income or deductions change this year, “chances are you will be OK” under such a shortcut, Giannangeli said.

- Complete the first five lines of the work sheet and skip the rest. That could work for taxpayers who have relatively little non-wage income. By not completing the rest of the work sheet, however, you will not account for any of your deductions, and thus you could be overwithheld.

- Figure your allowances based on how much tax was withheld last year. Many accountants and other tax experts are following this shortcut, which works if you do not expect any major changes in your income or deductions this year.

First, figure out how much of your income was withheld per pay period last year. Then consult a withholding table in IRS Publication 15 Circular E to see how many allowances this year correspond to that amount of withholding (most company payroll departments have withholding tables, and they might be willing to look them up for you). If you don’t expect major changes in your income or deductions, this new allowance figure could be fairly accurate.

IRS spokesman Giannangeli said he used this method. Last year he had 18 allowances. To get the same amount withheld, he referred to the tables and found that he needed to claim only 10 allowances this year.

However, if you had large deductions last year from tax shelters, IRAs or other types of investments that have been drastically affected by the new tax law, such a method will probably be inaccurate, Giannangeli said.

Q: Are there any shortcuts for two-income couples?

A: Yes. The IRS recommends that two-earner couples should use one work sheet and combine their incomes, itemized deductions, credits and other items. The spouse with the higher income should take all the withholding allowances to help ensure that the couple’s withholding is in line with the tax they will owe.

However, some couples who keep their finances separate may not want to follow this suggestion. For them, Ernst & Whinney’s Pearson suggests that the spouse earning the higher income at least take most of the allowances. That will generally result in an accurate calculation, provided that the income disparity between spouses is not enormous.

Q: If I want to complete the entire form, how do I figure adjustments to income on Line F?

A: Claiming these adjustments to income will lower your taxable income and give you more take-home pay. Thus, if you want to reduce your withholding, try to complete this section.

Although the work sheet instructions list five categories for adjustments to income, most taxpayers will be able to list only one, that for individual retirement accounts and Keogh plans. Items eligible for adjustments to income include:

- Qualified reimbursed employee business expenses. This includes business travel expenses such as transportation, meals and lodging. (Job-related expenses such as equipment, uniforms or education expenses are treated as miscellaneous deductions under Line G.)

But nearly all employees can skip this, since most employers reimburse expenses in cash payments upon submission of expense accounts, and the reimbursement is not counted as employee income. List expenses here only if your employer adds your reimbursement to your income reported on your W-2 form.

- Qualified alimony payments. Most alimony payments are qualified. Generally, alimony is qualified if it is included under a divorce decree or separation agreement and if the receiving ex-spouse reports the alimony as income.

- Deductible business and investment losses. Most taxpayers can ignore this section as well. Taxpayers with significant amounts under this category are likely to rely on professional tax help, particularly since the new tax laws change the rules on deductibility of such losses. It also is extremely difficult to predict such losses with any precision.

- Penalty on early withdrawal of savings. Nearly everyone can ignore this since you generally will not know in advance if you will incur such a penalty, said Judy Keisling, manager of tax research and training at H&R; Block, the tax-preparing firm. If and when you do incur a penalty, you could file a revised W-4, she said.

- Qualified contributions to an IRA or Keogh plan. New rules governing IRAs limit their deductibility for higher-income taxpayers. If you or your spouse is an active participant in an employer-provided retirement plan, your ability to deduct your IRA contribution will be phased out if your adjusted gross income is between $25,000 and $35,000 for single taxpayers, $40,000 and $50,000 for married taxpayers filing jointly, and zero and $10,000 for married taxpayers filing separately.

The rules for Keogh plans for self-employed individuals generally have not changed. You still may contribute and deduct up to $30,000, or 25%, of your non-deferred compensation, whichever is lower.

Q: How do I figure itemized deductions on Line G?

A: Itemized deductions also give you more allowances and thus increase your take-home pay. The work sheet instructions list eight categories of itemized deductions, but most taxpayers who itemize will be able to list only three: state and local taxes, mortgage and personal loan interest, and charitable contributions. The eight categories are:

- Medical expenses greater than 7.5% of your adjusted gross income. Most people, particularly those covered by medical insurance, will not have enough medical expenses to qualify for this deduction, Ernst & Whinney’s Pearson said. (Under the old law, it was easier to deduct medical expenses, as they needed to exceed only 5% of adjusted gross income.)

Under the new tighter rules, a taxpayer with an adjusted gross income of $20,000 would need $1,500 (7.5%) of out-of-pocket medical expenses just to begin qualifying for a deduction. And then only each dollar above that would be deductible. Thus, if that taxpayer had $1,600 in medical expenses, only $100 would be deductible. (To figure your adjusted gross income, take your total income and subtract any adjustments to income calculated on Line F.)

Thus, unless you anticipate major out-of-pocket medical bills, such as nursing home fees or major elective surgery, you can ignore this category, experts say. If you incur such bills later, you can always file a new W-4.

- State and local taxes. Because sales taxes are no longer deductible under tax reform, the only deductible state and local taxes most Californians need to worry about are property taxes and state income taxes.

Property taxes usually do not fluctuate, so it is generally safe to list what you paid last year, H&R; Block’s Keisling said. And unless you expect your income to change significantly, it is generally safe to list last year’s state income tax as well. You can get an approximation of last year’s state taxes from your W-2 issued by your employer.

If you expect your income to change this year, adjust last year’s state tax by the same percentage as your expected income change.

- Home mortgage interest and 65% of personal interest. This category will be significant if you own or expect to buy a home, or if you are paying loans to buy cars and other big-ticket items.

Mortgage interest on your first and second homes is still fully deductible under the new tax law, so you can generally list what you paid in 1986. If you do not own a home but plan to buy one later, you can always file a new W-4 after the purchase when you know the size of your mortgage payments.

Only 65% of interest on personal loans is deductible. This includes interest on credit card borrowings, auto loans, student loans and overdue tax payments.

That 65% limit on deductibility of personal loan interest will fall to 40% next year, 20% in 1989, 10% in 1990 and phase out entirely in 1991. Thus, if you borrow a lot through such loans, you may have to recalculate your W-4 every year.

- Qualified investment interest. Most people do not have enough of this to list. Investment interest in this case is any interest paid on borrowings to buy stocks, bonds, mutual funds, limited partnerships in which you have no active role in management, and any other investment in which you have no active role in management.

The deductibility of investment interest is limited under tax reform. It is deductible only up to the amount of net income from investments--the same types as listed above--plus 65% of any amount up to $10,000 that exceeds investment income. Thus, if your investment interest totals $11,000, but your net investment income totals $1,000, you can deduct only $7,500 (the $1,000 equal to the income plus 65% of the remaining $10,000.)

Similar to personal loan interest, the deductibility of investment interest will phase down to 40%, 20%, 10% and zero during the next four years. So those paying a lot of investment interest may have to recalculate their W-4s each year.

- Charitable contributions. Although non-itemizers may no longer deduct charitable contributions, itemizers still can. So list whatever you think you will give this year.

- Certain casualty and theft losses exceeding 10% of adjusted gross income. If you have insurance to cover major casualty and theft losses, you are highly unlikely to use this category. Your deductibles alone generally will not even come close to exceeding 10% of your adjusted gross income. If you suffer a major out-of-pocket loss later in the year, you can file a revised W-4.

- Unreimbursed moving expenses. If the expenses are reimbursed, list them only if your employer withholds tax on them.

- Miscellaneous deductions. Tighter rules under tax reform mean that most people probably will no longer have enough miscellaneous deductions to list here, Ernst & Whinney’s Pearson said. Miscellaneous expenses--such as unreimbursed employee business expenses, union and professional dues, trade magazine subscriptions, fees for investment and tax advice, and job-related education expenses--now are only deductible to the extent that they together exceed 2% of adjusted gross income.

Thus, a taxpayer with an adjusted gross income of $20,000 needs $400 of these expenses to even begin deducting anything. People who tend to spend more than that also tend to earn more, Pearson said.

Q: How about tax credits under Line K?

A: Tax credits, because they directly reduce your taxes dollar for dollar, are even better than tax deductions, and thus you will be remiss if you do not account for them. List any tax credit you plan to claim. The major credits include:

- Credit for child- and dependent-care expenses. The rules on this generally did not change, so it would generally be safe to include what you claimed last year. The credit is still generally based on your income and how much you spent on child or dependent care.

- Earned income credit. The new tax law increases the availability and amount of this credit, which allows low-income parents with children to keep more of the money they make. The maximum amount of the credit increases to $800 from $550, and the maximum income level at which it is no longer available rises from $11,000 last year to $14,500 in 1987 and $17,000 in 1988.

Unfortunately, however, tables allowing you to figure your new earned-income credit are not yet available, IRS spokesman Giannangeli said. Therefore, it is generally safe to simply record what you took last year.

Other credits that you can list here include the credit for elderly, and for permanently and totally disabled; foreign tax credits; credits for rehabilitation of historic buildings; low-income housing credits; carryforwards of residential energy credits and investment tax credits; job credits for employers hiring people from special groups, and research and development credits.

Q: Where can I go for more help?

A: Call the IRS’ toll-free telephone assistance line at 1-800-424-1040. Experts will answer questions from 8 a.m. to 4:30 p.m. Monday through Friday, and, time permitting, they are willing to walk you through the entire form. As a special service, the phone service will be open from 2 p.m. to 5 p.m. today.

Also, you can call the IRS at 1-800-424-FORM for copies of Publication 505 “Tax Withholding and Estimated Tax” and Publication 919 “Is My Withholding Correct?”

The IRS has an outreach program under which they will send experts out at companies’ requests to answer employee questions. IRS spokesman Giannangeli said 93 such visits have been scheduled already in the Los Angeles area. The IRS also has a videotape explaining the new form which it will send to employers upon request. Many companies plan to offer in-house seminars explaining the form.

Q: What if I make a mistake or my tax situation changes?

A: File a new W-4. You can file new forms each time your tax situation changes significantly. Your employer will make the adjustments in your withholding.