When Employees Want To Claim Exemption From Withholding

Employee Exemption Qualifications and Lock-In Letters

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In your company's payroll process, you may occasionally have an employee who wants to claim exemption from withholding. Having the facts will help you deal with this process.

Key Takeaways

  • Withholding is amounts taken from an employee's pay by the employer for state and federal income and other taxes.
  • Employees, if they qualify, may be exempt from withholding, and they must communicate this to you on a W-4 form.
  • The withholding exemption applies to income tax, but it does not apply to FICA tax (Social Security and Medicare).
  • If the IRS determines the employee exemption is invalid, it may send you a "lock-in" letter that instructs you to withhold income tax at a specific rate beginning on a specific date.

What Is Withholding?

Withholding is a general term for the amounts taken from employee pay for federal and state income taxes, and for FICA taxes (Social Security and Medicare). Some employees may not be required to have federal income taxes taken from their pay if their income is below a certain level.

The IRS allows employees to claim an exemption from income tax withholding in a specific year if both of these situations apply: 

  • In the prior year, they had a right to a refund of all federal income tax withheld because they had no tax liability
  • For the current year, they expect a refund of all federal income tax withheld because they expect to have no tax liability

Some types of employees may be exempt: students, part-time workers, those over 65, and blind employees. 

Note

Any withholding exemption applies only to federal income taxes, not state taxes or FICA taxes (Social Security/Medicare).

Claiming Exemption From Withholding

A new W-4 form is now in effect for all new hires and employees who want to change their W-4 forms. If an employee wants to claim exemption, they must write "Exempt" on Form W-4 in the space below Step 4(c) and complete Steps 1 and 5.

An employee who wants an exemption for a year must give you the new W-4 by February 15 of that year. If an employee who is currently getting a tax exemption expects to owe tax for the next year, they must change their W-4 by December 10th of the current year.

How To Know If an Employee Is Exempt From Withholding

You can only change withholding based on the documentation the employee gives you. Until the employee gives you the correct form or forms, you must continue to withhold federal, state, and local income taxes based on the most recent forms completed by the employee. You can't take the employee's word on the claim of exemption. 

You (the employer) may need to send the W-4 to the IRS for its review of the claim. You don't need to submit the form unless the IRS specifically sends you a letter requiring you to do this.

More About Withholding Exemptions

A claim of exemption from withholding does not exempt the employee from paying their share of FICA taxes, including the additional Medicare tax. All FICA taxes must be paid by both you as the employer and by the employee. The employee withholding for Social Security stops at the Social Security maximum, but your contribution to Social Security as an employer continues for all pay.

Note

If you think an employee's W-4 withholding exemption is incorrect, you can't change it, but you can advise the employee that the exemption may be questioned by the IRS. No matter what the employee claims, you must use only the signed W-4 form to withhold from employee pay.

The claim of exemption for federal income taxes has nothing to do with the employee's state income tax and local tax withholding. The employee will have to check with state and local taxing agencies to find out how this exemption works in those jurisdictions. As noted above, until the employee gives you the signed documents for the claim of exemption from state or local taxes, you must continue to withhold these taxes. 

If the employee wants to claim exemption from withholding, but they have already had withholding taken from their pay during the year, you can't refund them this money. At tax time, you will notify the employee of the withholding on their​ W-2 form for the year. The employee can then claim the amount withheld.

For example, Carlton comes to you in February and says he wants to claim exemption from withholding for this year. He completes a new W-4 form claiming exemption, but you have already withheld $276 in federal income taxes from his pay in January. He'll have to wait to file his tax return and claim the $276.

Don't assume that a student, part-time worker, or seasonal worker is going to be exempt from withholding. All employees must complete a W-4 form at hire, and this form is what the employee must use to claim an exemption. 

Note

Your attorney will tell you not to help employees complete forms. But if an employee asks you can give them information to help them make the decision on their own. IRS Publication 505 has a flow chart (Page 8) that might help the employee see whether they can claim exemption from withholding. 

If You Receive a Lock-In Letter From the IRS

You don't have to turn in W-4 forms to the IRS, but they can review an employee's claim for exemption and they can ask you to submit an employee's W-4 form. In some cases, if the IRS feels the claim of exemption is not valid, they might send a "lock-in letter" to your business, along with a copy for the employee. A lock-in letter locks in the employee's withholding based on the IRS review. 

This letter specifies the maximum number of withholding allowances permitted for the employee. Once you receive this lock-in letter, you must begin using this information to withhold federal income taxes from the employee's pay, effective with the date set by the IRS. You can't change the withholding amount until you receive permission from the IRS; you can't accept a new W-4 from the employee to change the withholding amount.

Note

You will also receive a copy of this letter for the employee explaining how to give the IRS additional information. You can encourage the employee to contact the IRS to request a change to the lock-in.

If you don't change the employee's withholding based on the withholding in the lock-in letter, your business is liable for paying the additional amount of tax that should have been withheld.

Frequently Asked Questions (FAQs)

How long must an employer keep employee W-4 forms?

You must keep employee W-4 forms in your records for four years to verify that you are withholding federal income taxes correctly. These forms, along with other forms signed by employees, must be available in hard copy format in case the IRS requests it.

What to do if an employee claims exempt on W4?

If an employee provides a W-4 that shows the employee is exempt from withholding, do not withhold federal income tax. According to the IRS, "to qualify for this exempt status, the employee must have had no tax liability for the previous year and must expect to have no tax liability for the current year."

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Sources
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  1. IRS. "Publication 17: Your Federal Income Tax," See "4. Tax Withholding and Estimated Tax."

  2. IRS. Publication 505: Tax Withholding and Estimated Tax." Page 7.

  3. IRS. "Withholding Compliance Questions and Answers." Question 1.

  4. IRS. "Publication 15 (2022), (Circular E), Employer's Tax Guide."

  5. IRS. "Withholding Compliance Questions and Answers."

  6. IRS. "Withholding Compliance Questions and Answers." Q8, Q9, Q10.

  7. IRS. "Topic No. 753 Form W-4 – Employee's Withholding Certificate."

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