According to the U.S. Department of the Treasury, 47.7 million individual tax returns were processed in the first four weeks of the 2019 filing season, and the average refund was $3,143. Refunds represent excessive income tax prepayments via withholding during the year.
Some taxpayers will adjust their W-4 withholdings to an exempt status to eliminate income tax prepayments in difficult economic times, but balancing this extra income with a potentially enormous tax bill can be challenging. You can use several factors to determine how long you can eliminate withholding taxes without experiencing too much economic fallout.
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Technically, you're only eligible for an exemption from withholding if didn't owe taxes last year and don't expect to this year. The exemption is only for federal income tax, not for Medicare or Social Security taxes.
The 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, such as allowing you to file exempt for one pay period. You will not be allowed to adjust your W-4 unless it results in more withholding until the expiration of this letter.
Appealing the Lock-In Letter
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 are listed on the lock-in letter, as is the address to mail the appeal.
Your employer is required to reject your form if you attempt to change your W-4 back before the date on the lock-in letter. Your employer can be required to pay the resulting liability if you change your W-4 online, which will likely lead to your dismissal and a legal or civil suit.
Look at Your Deductions
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 office expenses to mileage, you might 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.
Use the IRS withholding calculator found at IRS.gov to monitor this status.
Some Other Considerations
The IRS gives no maximum time that you can 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, there will be penalties of 0.5% per month, not to exceed 25 percent, for paying late. You can appeal this penalty if you have an acceptable reason for paying late. You can file Form 4868 with the IRS to ask for six more months to file your return, but this doesn't extend the payment due date.
- IRS: Form W-4
- NWTRCC: Controlling Federal Income Tax Withholding
- IRS: Topic No. 753 Form W-4 – Employee's Withholding Certificate
- IRS: Common Penalties for Individuals
- U.S. Department of the Treasury: Average Tax Refunds Up 19 Percent From Last Week and Consistent With 2018 Refunds
- IRS: Claiming Exemption From Withholding for Employers
- IRS: https://www.irs.gov/newsroom/filing-season-statistics-for-week-ending-december-27-2019
- Tax Brain: W-4 Tax Calculator
- Bankruptcy Law Network; Can I Reduce My Tax Withholdings to Avoid Paying the Trustee?; Chip Parker
- U.S. Internal Revenue Service: Publication 501 - Main Content
- U.S. Internal Revenue Service: Application for Automatic Extension