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Unlike Social Security and Medicare taxes, which are withheld at flat percentages of your pay, federal income tax is a multilayer affair. In the case of income tax, your employer determines your withholding conditions from your W-4 form. If you meet the requirements, you can claim to be exempt from federal income tax on the form. Withholding amounts vary by employee, but the exempt category has the same effect on all employees who claim it.
To figure out your federal income tax withholding, your employer obtains your filing status and number of allowances from lines 3 and 5 of your W-4. He applies the Internal Revenue Service Circular E tax-withholding table that matches the W-4 data plus your wages and pay period. If you claim exempt on line 7 of your W-4, your employer skips the withholding process. Exempt means that your employer does not withhold any federal income tax from your paychecks.
The IRS has strict regulations for claiming exempt. The general rules are stated on the W-4 for the respective tax year. In 2012, you’re exempt if in the previous year you received a refund of all your federal income tax withheld because you owed no tax and in the present year you expect a full refund because you don’t anticipate owing any tax. You may not claim exempt if someone else claims you as a dependent on her tax return and if your wages or non-wage income will exceed $750 for the year.
If you meet the qualifications for exempt, complete a W-4 and give it to your employer. Do not claim allowances plus exempt on the form; it has to be one or the other. Simply fill in your name, Social Security number, address and filing status. Then write “exempt” on line 7 and sign and date the form. If you put any allowances in box 5, even if it’s zero, you’re telling your employer to withhold federal income tax from your paychecks. Exempt is good for one year; if you meet the criteria for the following year, submit a new form to your employer.
You might be tempted to claim exempt to increase your take-home pay during the year. This comes with risks, because if you don’t qualify for it, you’ll owe the IRS when you file your tax return. Furthermore, the agency imposes penalties for providing false information on a W-4. This includes a $500 fee for making statements or claiming allowances to lower withholding and for having no reasonable basis for taking such action when you completed the form. If you're convicted of an actual crime, penalties may include imprisonment of up to one year or a fine of up to $1,000, or both. Penalties are effective only if you purposely falsified your W-4. A simple mistake, such as an honest calculation error, does not count.
If your state requires state income tax withholding, you might qualify for exempt under state law. If so, your employer does not take state income tax out of your paychecks. Whereas some states require employees to complete a W-4 for exemption from state income tax withholding, others require employees to fill out a different form. If you think you qualify, contact your state revenue agency for its guidelines on claiming exempt from state income tax.