How to Fill Out Your W-4 Form

If you've ever struggled to understand the instructions on a W-4 form, this Tax Forum's for you. W-4 is the form you fill out when you start a new job that tells your payroll department how much to withhold in taxes. We'll walk you through those calculations today. We'll also take on a trader's mark-to-market question and explain the taxability of nonqualified stock options.

Keep sending your questions to [e-mail], and don't forget to include your full name.

Exemption Confusion

I helped two people with roughly the same income ($15,000), one claiming zero exemptions on his return and one claiming one. There was a significant difference in the refund. Do you have any suggestions on what we are doing incorrectly?

-- Cpl. Douglas J. Karvecky

Douglas,

You're not doing anything incorrectly. It's all a matter of how much money you want withheld from your paycheck each pay period. More money withheld may mean a bigger refund in April. Less money withheld means more in your paycheck each week. It's your choice.

To start, you don't claim one or zero exemptions on your tax return. You make that election on Form W-4 -- Employee's Withholding Allowance Certificate. The problem is that the form is confusing and convoluted. So let's walk through the process now. (Also, see an earlier story on Form W-4.)

Here's the basic math. (Sit tight and I'll also tell you an easy way to do this): To figure out how much money you should have withheld from your paycheck each pay period, start with the 1999 personal exemption of $2,750. The exemption jumps to $2,800 in 2000.

Divide $2,750 by the number of pay periods in a year. If you get paid once a month, divide by 12 and you get $229. Multiply that number by your tax rate. If your income is around $15,000 and you're single, you're probably in the 15% tax bracket. So 229 x 0.15 = $34, or $408 a year.

Use those numbers, $34 a month or $408 a year, as your barometer when determining how many exemptions to claim on your W-4. The more exemptions you claim, the less money is taken out of your check each pay period.

For each exemption you add on your W-4, you'll take home $34 more per pay period or $400 more per year. If you elect three exemptions, that's another $102 per pay check or $1,224 for the year in your take-home pay.

Your friend who elected zero had the highest possible withholding taken out of his paycheck each month. If he's getting a lot of it back, that might mean he's had too much withheld all year long. Maybe he should consider putting down "1" so he can take advantage of his money throughout the year.

Use your 1999 tax return as a gauge for 2000. If you're getting a big tax refund this year, you might want to decrease your withholding tax so Uncle Sam doesn't get the pleasure of playing with your money all year long. But be careful, you don't want to owe money in April. Also keep in mind that there are penalties for under-withholding.

The Taxes4Less.com Web site has a calculator that'll do all this for you.

New Trader Wants to Mark to Market

Regarding this article Key Tax Deadline for Traders Comes Earlier Than Expected, what happens if 1999 was the first year you traded securities and you want the mark-to-market election to apply? Say you started trading in June 1999, you had already filed your tax return for 1998. Does that mean it's too late to make the election?

-- Chris Hugo

Chris,

If you did not make the election on your 1998 tax return, you cannot mark to market your trades on your 1999 tax return. I'm sorry to say, the Internal Revenue Service is not giving anyone a break on that point.

The mark-to-market election allows traders to value their securities as if they were sold for their fair market value on the last business day of the year. It's only a paper transaction, but it can be a key tax perk because it allows traders the option of taking an unlimited amount of losses, which can be used to offset any income.

If you're interested in marking to market your trades in 2000, be sure to make the election with your 1999 tax return.

Stock Options and Social Security

I know that income taxes will be withheld when I exercise stock options. What about Social Security contributions?

-- Philip B. White

Philip,

Since you are having tax withheld on your options at exercise, I assume you're referring to nonqualified options.

When you exercise nonqualified options, the difference between the stock's fair market value on the date of exercise and the actual exercise price is considered ordinary income. That spread will show up on your Form W-2 as compensation because, essentially, you are buying the shares from the company. (This is very different from incentive stock options, which are not taxed as compensation. See this previous Tax Forum for more on differences between incentive stock options and nonqualified options.)

Since the spread is reported on your W-2, "the whole nine yards are withheld," says Rande Spiegelman, a senior manager in KPMG's investment advisory-services group in San Francisco. That includes federal and state taxes as well as FICA -- Social Security and Medicare.

But don't forget, Social Security tax is 6.2% of the first $72,600 of wages for 1999. (The wage amount jumps to $76,200 for 2000.) There is no withholding on your W-2 income above that $72,600. Medicare withholdings have no limit though. So 1.45% will be withheld on all your W-2 income.