What Do Tax Allowances Mean & How Withholding Works Now
Gain clarity on how income tax is withheld from your pay. Understand the current system to effectively manage your tax deductions.
Tax allowances previously played a central role in determining federal income tax withholding. While no longer present on federal tax forms, this system allowed individuals to adjust the amount of tax taken from each paycheck. Understanding its historical application helps comprehend the evolution of tax withholding. This article clarifies the past meaning of tax allowances and explains the current system for adjusting tax withholding to align with an individual’s financial situation.
Understanding Tax Allowances Historically
Before 2020, the Internal Revenue Service (IRS) Form W-4, known as the Employee’s Withholding Allowance Certificate, utilized “allowances” to guide employers on how much federal income tax to withhold from an employee’s pay. Each allowance claimed reduced the amount of tax withheld from a paycheck. The purpose of these allowances was to account for factors that decreased an individual’s taxable income.
These factors included personal exemptions for the taxpayer, their spouse, and dependents. Individuals could also claim additional allowances for certain itemized deductions or tax credits they expected to take when filing their annual tax return. A higher number of allowances typically resulted in less tax withheld, leading to larger paychecks, while fewer allowances meant more tax withheld and smaller paychecks. The goal was to match withholding to estimated tax liability, aiming to avoid a large tax bill or an excessively large refund at tax time.
The Shift Away from Allowances
The primary reason for the elimination of tax allowances was the Tax Cuts and Jobs Act (TCJA) of 2017. This legislation made significant changes to the tax code, including setting the personal exemption amount to zero for tax years 2018 through 2025. Since personal exemptions were foundational to the allowance system on the old Form W-4, their suspension necessitated a redesign of the form.
In response, the IRS released a redesigned Form W-4, effective for 2020, which removed the concept of allowances entirely. The new form aimed to make withholding more transparent and accurate by directly linking it to specific tax credits and deductions, rather than relying on an abstract allowance number. The IRS sought to simplify the process for taxpayers and reduce confusion that often arose from trying to determine the correct number of allowances to claim.
How Current Withholding Works
The current Form W-4, officially called the Employee’s Withholding Certificate, no longer uses allowances but instead guides employees to account for their specific tax situations. This form helps employers calculate the correct amount of federal income tax to withhold from each paycheck.
The form is structured into five steps, with Steps 1 and 5 being mandatory for all employees. Step 1 involves entering personal information, such as name, address, Social Security number, and filing status (e.g., Single, Married Filing Jointly, Head of Household). Steps 2 through 4 are optional but are important for individuals with more complex tax situations. Step 2 addresses multiple jobs or a working spouse, while Step 3 is for claiming dependents by entering the total amount of qualifying child tax credit and credit for other dependents. Step 4 allows for other adjustments, such as reporting non-job income (like interest or dividends), itemized deductions, or requesting additional tax withholding per pay period.
Steps to Adjust Your Withholding
Adjusting your federal income tax withholding now involves using the current Form W-4 and often the IRS Tax Withholding Estimator. This online tool helps individuals determine how much federal income tax should be withheld from their paychecks. It considers various factors to estimate your yearly tax and suggests how to complete your W-4 for accurate withholding.
To begin, gather your most recent pay stubs, information for other income sources, and your most recent income tax return; these are helpful for using the estimator. The IRS Tax Withholding Estimator does not ask for personal information such as your name or Social Security number. After using the tool, it provides recommendations on how to fill out the current Form W-4 to achieve your desired withholding.
Next, obtain a current Form W-4 from the IRS website. Fill out Step 1 with your personal information and filing status. If you have multiple jobs or a working spouse, complete Step 2, which offers options like using the estimator, checking a box if there are only two jobs with similar pay, or using the Multiple Jobs Worksheet. For those with dependents, Step 3 allows you to enter the total amount of qualifying child tax credit and credit for other dependents you expect to claim.
Finally, Step 4 provides lines for other adjustments. Use line 4(a) for other income not subject to withholding, such as interest or dividends, if you want additional tax withheld. Line 4(b) is for entering itemized deductions or other adjustments that reduce your taxable income, potentially decreasing your withholding. Line 4(c) is for requesting any additional amount of tax to be withheld from each pay period, useful for covering taxes on side income or increasing withholding to avoid owing tax at year-end. Once completed, submit the Form W-4 to your employer’s payroll department.