Exempt Yourself from Questions: Clarifying “Tax Exempt”

May 23, 2019

Tax Exempt status on an employee W-4 can impact employers too. Learn what it means to be tax exempt, and why you should double check employee forms.

tax exempt blog cover

When a company hires a new employee, part of the new hire paperwork is the W-4 form.  The purpose of the W-4 is to help the employer notate the withholding tax from an employee’s paycheck.  But let’s be honest… most employees (and maybe employers) have no clue what that form actually means, or how the completion of it affects their taxes. 

One of the biggest mistakes you can make on a W-4 form is marking “exempt” when you’re not actually exempt. Uh-oh.  Could you be one of those people who claimed to be exempt when you shouldn’t have?  If so, it’s not the end of the world, but you will need to correct that.

Ok, let’s get down to business clarifying the meaning of “tax-exempt” so we can make sure your withholding status is correct. If your withholding status is correct, your taxes are being withheld appropriately.  The last thing anyone wants is the IRS breathing down your neck for something you don’t understand.

The Elusive W-4 Form

So, since we know the purpose of the W-4 is to determine withholding taxes, let’s go into a little more detail to pinpoint where the confusion lies. 

The W-4 is a worksheet comprised of three different sections on one page. The first section explains the purpose and components of the W-4.  The second section is the Personal Allowances Worksheet that employees are supposed to keep for their own personal records. This page helps people understand and remember how they calculated their allowances. 

Finally, the third section is the Employee’s Withholding Allowance Certificate, which is where everything is added together, and the document is made official with the employee’s signature and the date.  The third section is the part that employers need to keep on file. However, many employees simply submit the entire form to their Human Resources department. If necessary though, you can keep your calculations for future reference and use.

married couple and the woman is thinking, "i hope i remember to update my W-4 on Monday"

Once the employee signs and submits the W-4, the form is valid indefinitely. Or at least until the employee needs to make changes on the form, and therefore would have to complete a new one. 

Some events that lead to an employee updating a W-4 include:

  • Marital status
  • Exemptions
  • Adjustments
  • Deductions
  • Credits

It’s crucial to recognize the W-4 form will affect how the employee’s taxes are withheld, and therefore, their take-home paycheck.

Tax-Exempt Employees

So, who’s an example of someone who could accurately claim to be tax-exempt on the W-4 form?

The first thing to make clear is that an exempt employee is different from a tax-exempt employee, or someone who can claim an exemption on the W-4.  An exempt employee is a worker who is exempt from overtime wages, and this is typically an employee who receives a salary, as opposed to being paid an hourly rate.  So, being classified as an exempt employee is not the same as claiming “exempt” on your W-4.

To claim exempt status on your W-4, the IRS says that the employee will need to be able to confirm two conditions.  These two items are based on the previous year’s tax refund, as well as an estimation of the current year’s tax refund.  So, if an employee received a full refund of FIT (Federal Income Taxes) for the prior year because of not having any tax liability, then that checks one box.

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Secondly, if the employee anticipates a full refund for the current year due to having no tax liability throughout this, then that checks the box number two.  If both of these conditions have been met, then an employee can claim “exempt” on the W-4 form.

At this point, you’ve probably realized these fluid conditions mean employees must ensure they’re on top of keeping an updated W-4 on file with your company. The reason being, it’s possible for their tax liability to change from year to year.  If they claim tax-exempt, that status will expire each February. So, encourage employees to set a reminder in their planner to reevaluate their status annually. 

Additionally, should an employee no longer be exempt at any time during the year, they only have 10 days to update the W-4 (that means they typically must have the new W-4 in place within one pay cycle).

Mistakenly Claiming Tax-Exempt

So what happens if an employee incorrectly claimed “Exempt” on the W-4?  Well, first of all, the employee will probably notice immediately that his/her paycheck is higher than anticipated. The reason being, no FIT taxes have been withheld.  Lucky for them, the other taxes (Social Security, Medicare, and the Federal Unemployment Tax) will not be impacted. This is also lucky for the employer because the other taxes require an employer portion to be paid to the IRS.

Second of all, doing nothing about an incorrect tax-exempt W-4 is not an option.  Do you remember what you learned about the exemption status changing at any point during the year?  An employee only has 10 days to update the W-4.  This means they must update their W-4 immediately if they’ve made a mistake and claimed exemption. 

Third, you’ll have to compensate for the taxes that weren’t withheld.  Luckily, there are several options for ways an employee can make up for the deficit in taxes.

Correcting the Issue

The first option for making up the deficit in taxes is that the employee can update the W-4 to have extra taxes withheld from their paycheck.  When looking at line 6 on the Employee’s Withholding Allowance Certificate, you’ll see, “Additional amount, if any, you want withheld from each paycheck…” This is where an employee would decide how to make up for the deficit. 

They can estimate how much they should have had withheld and make it up in a lump sum.  Another option is to withhold the additional amount over time.  If the employee would like to break out the deficit amount into smaller figures and make up for the sum throughout the year, they can do it in this box.  Either way, it’s up to the employee. 

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The second option is to pay a lump sum directly to the IRS.  This requires the employee getting in touch with the IRS office and make arrangements for payment.  If the employee explains the situation to an IRS agent, they should be able to advise on the best way to go about their situation.

The third option is for the employee to wait to file his/her tax return to find out the actual amount owed (if he/she does, in fact, owe anything). Then, they would just write a check to the IRS.  The amount owed depends on how many pay periods the employee did not have FIT withheld.

The Employer’s Responsibility

We’ve determined that if an employee mistakenly claims to be tax-exempt on the W-4 form, the FIT taxes will not be withheld from paychecks.  So, what does this mean for the employer when this happens? 

Since the employer has no say in how much FIT to withhold from a paycheck, it is entirely the responsibility of the employee to make sure that he/she completes the worksheet correctly. Remember, the HR department might be able to help answer some questions along the way.  If an employee realizes that he/she mistakenly claimed exempt, then the employee will need to make sure their employer has an updated W-4 with the correct information.  From there, the employer’s payroll department or service ensures the withholding amount is accurate going forward. 

One way to catch an issue before it happens is to review your employee’s paperwork before submitting it or updating their withholdings. If reviewing their paperwork shows, they may have made a mistake, double check with them. Ensure your employees know the meaning of exempt.

Don’t Be Clueless

The most important thing to note is that ignorance is not bliss—an employee’s withholding status needs to be correct.  The IRS won’t buy “I don’t know” for an excuse. So, arm yourself with information regarding this subject.  Inaccurately claiming to be exempt on a W-4 form could lead to costly back-taxes for the employee. 

Unnecessary headaches for employees can affect their performance, so in a roundabout way, it affects the employer as well.  So, do everyone a favor, remind them to review the W-4 form and ensure their taxes are properly withheld.

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