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Typically, a taxpayer must deal with at least two documents: the W-4 form that she fills out so her employer can calculate payroll taxes, and her annual tax return. You claim withholding allowances on a W-4, but you claim exemptions on your tax return. Both allowances and exemptions reduce the bite taxes take, and they are related. However, there are some important differences, and understanding these differences will help you better manage your taxes.
A withholding allowance is a specific amount your employer subtracts from your gross pay before calculating how much federal income tax to take out of your earnings each payday. The amount of a withholding allowance is based on an annual figure determined by the Internal Revenue Service. For example, the basis for 2012 was $3,800. The amount subtracted for each paycheck is calculated by dividing the basis by the number of times you are paid each year. If you get a paycheck every two weeks, divide $3,800 by 26 for an allowance of $146.15 per pay period.
The term "exemption" refers to a type of tax deduction on your tax return. The IRS calls this deduction a personal or dependent exemption. As of 2012, the amount of an exemption was $3,800, which is the same as the withholding allowance basis. That’s not an accident. By the end of the year, each withholding allowance will exclude exactly the same amount from your taxable pay that a personal or dependent exemption excludes from your taxable income on your tax return. The idea is that your employer calculates your withholding so that it is about equal to the amount of tax you will actually owe at year’s end.
Although you normally claim one allowance on a W-4 and one exemption on your tax return for yourself, your spouse and each dependent, withholding allowances have other uses that exemptions do not. You can claim an extra allowance if you have only one job. You may also add one or more withholding allowances if you qualify for the Child Tax Credit or Child and Dependent Care Credit on your tax return. This reduces the amount of payroll tax withheld by approximately the amount of the credit on your tax return. Again, the goal is to ensure that the amount of tax withheld is about what you will owe at the end of the year.
The amount of taxes you actually owe is determined when you prepare your tax return each year. Payroll tax withholding is only an estimate and does not take into account things like a spouse who works, investment earnings or self-employment income. The IRS does not allow you to claim more exemptions or withholding allowances than you are entitled to, but you can claim fewer allowances on your W-4 form. You may also ask your employer to take out an extra dollar amount by submitting a new W-4 form. These options can help you adjust the amount of payroll tax withheld so that you do not have a large tax bill when you file your tax return.