Claiming 'Exempt,' Multiple State Taxation, and More

Several times during each tax season, a client will call and ask if it is okay to claim "exempt" on his W-4 when he starts a new job. It seems that the person is in dire need of all the cash he can get, and feels that by claiming "exempt," he will come out fine. Not so! Let us explain.

The "exempt" category is designed for people who will have absolutely no tax liability. That means that when your taxes are filed, the government will not keep even one dollar of your earnings for taxes. The "exempt" category was meant for people like college students who took on a summer job between semesters. Usually, the couple of thousand dollars they might earn during the summer will result in zero tax liability, providing that was their only job all year. Since there would be no tax liability, there would be no reason to withhold taxes from the paycheck.

If, however, you do have a tax liability when you file, but you claimed "exempt" on your W-4, you could be assessed a civil penalty of up to $500. We have written in the past that it is allowable to claim seven, eight, or nine exemption allowances in an effort to take home more money each paycheck. This is okay, but to claim "exempt"—definitely not!

This reminds me of the several instances over the past few years when parents of child performers filled in their kid's W-4s and claimed "exempt." Granted, their child was a full-time student, but the kid earned $95,000 in commercials! Obviously, there was a tax liability—and a hefty one at that. The parents were horrified at the amount owed because not one dollar was withheld. They said they were told that filing "exempt" would be okay because their child was a full-time student. What a painful surprise!

Clients often tell us, "It doesn't seem fair to be taxed by two states on the same income." They are referring to the fact that when you work in a state other than the one in which you live, taxes are withheld, and you must file both with that state and with the state of your residence.

What these clients don't realize is that all states have a provision for avoiding that "double taxation." For instance, if you reside in New York State and worked at the Goodman Theatre in Chicago, you can get a credit on your New York State return for the taxes paid to Illinois. This is called a "Resident Tax Credit." Simply file Form IT-112R along with your New York State return and attach a copy of the Illinois nonresident return that you filed. New York will subtract from your New York tax bill all or part of the amount you paid to Illinois. By doing this, you avoid paying taxes to two states for the same income.

Sounds confusing? A little, perhaps, but your tax consultant will know about it. Remember, you must pay taxes to your state of residence on your entire income, no