The federal government forces employers to take a piece of your paycheck out and set it aside for the federal income taxes you expect to owe at the end of the year. When you file your income taxes, you receive credit for the amounts withheld. The amount your employer withholds is affected by the number of allowances you claim on your Form W-4.
Effect of Each Allowance
Each allowance you claim reduces the amount of your paycheck that's subject to federal income tax withholding. Since most employees are paid more than once per year, the value of the allowance is divided by the number of pay periods in the year. The more allowances you claim, the smaller the amount your employer takes out for federal income taxes. You inform your employer how many allowances you want to claim by completing a Form W-4. As your life circumstances change, you may need to file updated Form W-4s to accurately reflect how many allowances you wish to claim.
Number of Permitted Allowances
To figure the number of allowances you are entitled to claim, most people complete the Personal Allowances Worksheet, which is part of the IRS Form W-4. This worksheet estimates the number of allowances you are allowed based on information you provide, such as your filing status, the number of jobs you work and the number of dependents you claim. If you plan to claim significant income tax deductions, use the Deductions and Adjustments Worksheet, also found on Form W-4. If you work multiple jobs, or are married and both spouses work, use the Two-Earners/Multiple Jobs Worksheet. These alternative worksheets provide a more accurate estimate in certain circumstances.
Claiming More Allowances
Just because you find yourself eligible to claim several allowances does not mean you must claim all of them. The more allowances you claim, the lower your income tax withholding, which results in either you owing more money at tax time or receiving a smaller income tax refund. Some people prefer to receive a large refund at tax time rather than having less withheld during the year; but when you do so, you give the federal government an interest-free loan on your taxes that you could be using to pay down your other debts during the year.
Do Not Claim too Many
If you claim more allowances than you are allowed, you could face civil and criminal penalties. If you claim too many allowances, your withholding will not equal the minimum amounts needed to avoid under-withholding penalties from the IRS, which will charge interest and penalties on the shortfall of your withholding. If you intentionally claim too many allowances, you could also face up to a year in jail and other monetary fines.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."