Withholding Allowances: What Are They, And How Do They Work?

Taxes can be confusing and for those starting their first job the subject of withholding allowances may be overwhelming. We are taking a look at withholding allowances, asking what are they and how do they work to help you understand this important subject. 

What Is A Withholding Allowance?

A withholding allowance is the exemption that will reduce the amount of income tax that an employer deducts from an employee’s paycheck. An exemption reduces the amount of your income that is subject to income tax. 

When you start a new job you will claim a withholding allowance on the Inland Revenue Service’s Form W-4. Your employer will then calculate the amount to be withheld from an employee’s paycheck for tax purposes. 

This money is then paid to the Inland Revenue Service in your name by your employer. You can choose to claim between 0 and 3 withholding allowances depending on your filing status. 

The more withholding allowances you have the smaller the amount of income tax deductions from your paycheck. Fewer allowances mean more of your paycheck will be withheld for tax purposes.

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How The Withholding Allowance Works

A new employee will be given Form W-4 when they start work. This form is used to claim withholding allowances and includes their personal information and social security number. 

The employer uses the form to determine how much of the employee’s paycheck to withhold. The amount withheld will depend on the number of allowances claimed by the employee, this in turn is determined by the employee’s filing status. 

Your filing status depends on whether you are single, married and filing jointly, married but filing separately or head of household. 

Claiming the correct number of allowances is important to avoid issues when filing your taxes. If you don’t claim the right amount of withholding allowances you may end up paying too much in tax only to get a refund later. 

Also read: Calculate Net Income
 

How Withholding Allowances Are Calculated

The withholding allowances you claim depends on your individual circumstances and filing status. This includes whether you have more than one job, your spouse works or you have children who are dependent on you. Other adjustments also apply. 

For those with children a withholding allowance applies if the taxpayer is claiming the child tax credit for a qualifying child or other dependent. 

The allowance may also be based on itemized deductions rather than standard deductions, whether you or your spouse have more than one job and on the amount of your total income. Personal exemptions no longer apply when calculating the withholding allowances. 

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Who Has Withholding Allowances?

A single person with no dependents who takes the standard deduction can claim one withholding allowance for themselves and another if they have only one job. 

Married taxpayers who file jointly, have no children and claim the standard deduction, can claim one for themselves and another for their spouse. 

A third allowance can be claimed if they have only one job, their spouse does not work or if a second job or their spouse’s job pays $1,500 or less. 

Taxpayers with children or other dependents can claim withholding allowances based on their income. There is a withholding allowance calculator provided by the IRS which allows those with children to check they are claiming the right number of allowances. 

Exemption from withholding allowances is a difficult status to achieve. However it can be claimed only if you have the right to a refund for all federal income tax which was withheld the previous year. 

This would be because you had no tax liability in that year and the same is expected for the current year. 

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What Is Estimated Tax?

If you don’t pay your tax through withholding you will have to pay estimated tax. This is typically how people who are self-employed such as freelancers, small business owners and independent contractors pay their taxes. 

It is a quarterly payment for the year based on the reported income of the filer and is applied to any kind of taxable income that is not subject to withholding. This can include earned income, rental income, capital gains, interest income or dividend income. 

The IRS requires those who are liable for estimated tax to make payments quarterly. When the taxpayer files their tax paperwork for the year they will either pay the balance due or request a reimbursement for any overpayment. 

How To Check And Change Your Withholding Allowance

You should check your withholding amount especially if you have had major life changes such as getting married, divorced, having children, retiring or anything that affects your filing status. 

The best time to check is early in the year so that you are prepared for the changes before the start of the tax year. You will also need to check your withholding if there has been a change in the tax law. 

Fill in a new Form W-4 when your personal or financial situation changes. The new withholding allowance will go into effect within the first pay period ending 30 days after the revised W-4 is sent to your employer. 

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Can You Claim Too Many Allowances?

If you claim too many allowances you will find that at tax time you owe money as you will have underpaid your taxes during the year. This can result in a penalty when you file your tax return. 

If you claim no allowances but do not have enough withheld from your paycheck you can request that your employer withhold an extra dollar amount. On the flip side, if you have more income withheld than needed you are entitled to a refund after filing your tax return. 

Final Thoughts

As an employee it is important to understand the withholding allowances and ensure that you are claiming the right amount. Not withholding enough means you may be paying extra when you file your tax return and could cost you a penalty. 

We hope that this guide to withholding allowances has been helpful to you. 

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