What Does an Allowance Mean in Taxes?
Demystify a key historical tax term. Learn how income tax was managed in the past and grasp the current approach to payroll deductions.
An “allowance” in taxes previously referred to a system employers used to determine federal income tax withholding from paychecks. This concept was central to tax withholding but has since been redesigned. This article explains what allowances were and how federal income tax withholding operates today.
Understanding the Concept of Allowances
Before 2020, employees used “allowances” on IRS Form W-4 to help employers calculate federal income tax withholding. Each allowance claimed reduced the amount of tax withheld from a paycheck. The purpose of claiming allowances was to align the amount of tax withheld with an individual’s actual tax liability for the year.
Taxpayers could claim allowances for themselves, their spouse, and dependents. Additional allowances were claimed for certain tax benefits, such as itemized deductions or tax credits. A higher number of allowances meant less tax was withheld, aiming to prevent over-withholding and a large refund. Conversely, claiming fewer allowances meant more tax was withheld, potentially reducing any tax due when filing an income tax return.
The Transition from Allowances
The concept of withholding allowances was removed from the federal income tax system due to significant tax law changes. The Tax Cuts and Jobs Act of 2017 (TCJA) brought about substantial reforms, including changes to tax rates, deductions, and credits. These changes made the previous allowance-based withholding system less effective in accurately reflecting an individual’s tax situation.
To address this, the IRS redesigned Form W-4, which became effective for all employees starting January 1, 2020. This updated form eliminated withholding allowances entirely. The redesign aimed to simplify the withholding process and make it more transparent for taxpayers.
How Tax Withholding Works Now
The current federal income tax withholding system, based on the redesigned Form W-4, no longer uses allowances but relies on more direct information. Employees now provide personal details that help employers determine the correct amount of tax to withhold. This process begins with Step 1, where individuals enter their name, Social Security number, and filing status, such as single, married filing jointly, or head of household.
Step 2 on Form W-4 addresses situations where an employee has multiple jobs or is married and their spouse also works. This step helps ensure enough tax is withheld to cover combined income from all sources, preventing under-withholding. Options include using a tax withholding estimator, checking a box for multiple jobs, or completing a worksheet to allocate income and deductions.
Step 3 allows individuals to account for dependents, which can reduce their tax liability through tax credits. For example, the Child Tax Credit can lower the amount of tax owed, and this step helps adjust withholding accordingly.
Step 4 provides options for other adjustments to withholding. This includes reporting other income not subject to withholding, such as interest or dividends, or claiming deductions other than the standard deduction, like itemized deductions. Individuals can also specify an additional amount of tax they wish to have withheld from each paycheck in this step.