According to an article by Blake Ellis published on the CNN/Money website, there were 45 million taxpayers who received tax refunds in 2010 averaging a whopping $3,129. In challenging economic times, some will adjust their W-4 withholdings to an exempt status to eliminate income tax prepayments. Balancing this extra income with a potentially enormous tax bill can be challenging. There are several factors you can use to determine how long you can eliminate withholding taxes.
IRS Exemption Policy
The IRS allows you and your employer to agree on your exempt status; however, the organization reviews this status to verify its validity. The IRS may immediately or over time remove your right to file exempt and contact you and your employer, commanding you to withdraw taxes. This letter is referred to as a "lock-in letter." The IRS must give a time frame during which the lock-in letter applies. You will not be allowed to adjust your W-4, unless it results in more withholding, until the expiration of this letter.
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You can appeal the lock-in letter to attempt to continue your exempt status. To do so, you must provide documentation as to specific reasons why you need to claim exemption. The appeal process and required documentation is listed on the lock-in letter, as is the address to mail the appeal. If you attempt to change your W-4 back before the date on the lock-in letter, your employer is required to reject your form. If you change the W-4 online, your employer can be required to pay the resulting liability, which will likely lead to your dismissal and a legal or civil suit.
Your personal tax deductions and general tax situation should dictate your request for exemption. If your spouse is self-employed and you have a wealth of deductions ranging from home expenses to mileage, you may be able to balance out a longer time being classified as exempt. If you typically pay taxes each year as opposed to getting a refund and have difficulty meeting this obligation, filing exempt will likely make this situation worse. Utilize the IRS withholding calculator found at IRS.gov to monitor this status.
The IRS gives no maximum time that you may be on an exempt status. You must balance the potential tax bill with the zero interest loan you give the IRS if you withhold too much and end the year with a large refund. If you end the tax year with a bill that you cannot pay at the tax deadline in April, you can file an extension using tax form 4868. There will be penalties of .5 percent per month, not to exceed 25 percent, for paying late. You may appeal this penalty if you have an acceptable reason for filing late.