Withholding allowances reduce the amount of income tax your employer deducts from your paycheck. You provide instructions to your employer on the number of withholding allowances you need by completing IRS Form W-4. Your employer uses this information to determine the amount of your pay to withhold and remit to the IRS. The more allowances you claim, the less income tax is withheld from your paycheck.
How Tax Withholding Works
Each allowance you claim equals a certain amount set aside from your pay. Your employer takes the leftover amount and applies a tax formula to figure out how much income tax to withhold from your paycheck. So, the more allowances you claim means more money set aside and a smaller amount for your employer to apply the tax against.
You can check the proper amount of withholding allowances for your situation by using the calculator on the IRS website. However, if you're going to owe taxes for self-employment, alternative minimum tax or you've got qualified dividends or long-term capital gains, the withholding calculator won't be accurate. For more complex situations like this, you can find help in IRS Publication 505, Tax Withholding and Estimated Tax.
Figuring Your Withholding Allowances
The IRS provides a worksheet, called the personal allowances worksheet, as part of the W-4 form. This takes you through the process of figuring out the number of allowances you can claim. You'll start by entering one allowance for yourself, and add allowances for different situations, such as one more allowance if you have a spouse, one more allowance for each dependent you have, and another allowance for head of household. You can take additional allowances depending on your income range and other factors.
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Using the Wrong Number of Allowances
Increasing your withholding allowances gives you more money each payday to feed your family and pay your bills. However, if you claim too many allowances, there's a chance you'll owe money once you file your taxes. If you significantly under-withhold for your taxes, you could be assessed a penalty when you file your return.
If you take too small a number of withholding allowances, you'll have taxes assessed on a larger portion of your income and get a refund of your money once you file your annual tax return. Getting a refund isn't the best idea though because you could have used this cash to either invest or pay bills during the year. You're essentially making an interest-free loan to the government if you have too much money withheld from your paycheck. If you find yourself in this situation, you can change your withholding allowances at any time by completing and submitting a new W-4 to your employer.
Breaking Even at Tax Time
If you'd like to break even so that you neither owe nor get money back when you file your annual income tax return, ask your accountant or employer's payroll department to help you do a calculation to determine the number of withholding allowances to break even, based on your specific situation. You can also consult IRS Note 1036 for instructions on how to calculate your withholding tax based on a percentage method. This method takes into consideration your filing status and income range. You'll need your previous year's tax refund amount, and the publication supplies tables with an annual dollar value of each additional withholding allowance to figure out a more precise number of withholding allowances to claim. You can also use the information to multiply the annual withholding allowance value by the number of extra allowances you want to claim to estimate how much your monthly take-home pay increases.