What are withholding allowances and how do they work?
If you’ve ever had a job, you have filled out Form W-4. My guess is that you did the worksheet on the back, looked at it, closed your eyes, and just picked a number for the number of “allowances” you wanted to claim.
I’m going to share today about what an allowance is and just how it affects your bottom line.
So, what exactly is an allowance?
According to the IRS website, an allowance is used to calculate how much you have withheld for federal taxes each paycheck. It represents an amount of income that should not be taxed.
The government wants you to pay in, through withholding, as much income tax as possible each pay period. But you have a spouse who works (and who is also paying into the system), kids, or just other things you want to do with your money besides pay taxes. So you want to tell Uncle Sam, “Hey! That’s not fair. I have 3 kids. You should make allowances for that.” Or, “My spouse works, too. We don’t need to pay in double. You should make allowances for that.”
That’s basically what happens when you choose your number of allowances on your W-4. When your paycheck is calculated, the payroll software will put the number of allowances into a formula that determines how much tax is taken out of your check. Since you are asking for the government to make allowances for your situation, the more allowances you claim, the less tax will be withheld and the bigger your paycheck will be.
You might be thinking, “This sounds great! I’ll just claim a bunch of allowances and get the biggest paycheck possible!”
Not so fast! When it’s time to file your taxes for the previous year, you will look at your W-2 to see how much income taxes you paid in through withholding. You’ll then compare that to your tax liability to determine if you paid too much or too little income tax already. If you paid in too little, you will have to write the government a check (or pay online) when you file your taxes.
How many allowances should I have claimed?
At this point, you might be thinking, “OK. I don’t want to have too little withheld and end up owing money at tax time. But I don’t want to have too much withheld and have to live with a smaller paycheck. So how many allowances should I claim?”
My answer is, it depends. The amount of tax you owe is determined by your filing status and the amount of income you earned (and a million other factors that we can’t go into here because it would make this blog longer than a tax law document).
The main takeaway from this post is this: the more allowances you claim, the bigger your paycheck, and the less tax you pay in during the year. The fewer allowances you claim, the smaller your paycheck and the more taxes you pay in during the year. The balance is finding the right amount of allowances to provide sufficient income throughout the year without having to pay more income tax at the end of the year than you’re comfortable doing.
How can I help?
I offer payroll services to my bookkeeping clients with 1 to 5 employees. Along with advice from your tax preparer, we will discuss how many allowances you should claim. If you fit this profile and want some help, give me a call.