When it comes time to file your taxes, the chances are good that you are in no short supply of questions and/or concerns. After all, with the myriad of opportunities available to reduce your tax liability via allowances, exemptions, deductions and credits, many individuals are afraid that they are missing out on highly valuable savings.
The terms "allowance" and "exemption" come up often in terms of tax filing, but some confusion exists as to what each refers to specifically. Whereas exemptions are notated on the Internal Revenue Service Form 1040 and serve to reduce your overall taxable income amount, an allowance is claimed as part of the W-4 process and allows you to withhold the amount of tax taken out of each paycheck.
Exemptions are used to reduce your total taxable income as per federal and state guidelines. An allowance, however, is used to reduce the specific amount of tax taken out of your regular paycheck. Exemptions help reduce your total tax liability, but allowances do not.
The Basics of Exemptions
Broadly defined, an exemption acts as a lawful means to reduce the amount of income that the IRS and state governments will examine in order to determine your annual tax bill. Prior to the introduction of the Tax Cuts and Jobs Act, both personal and dependent exemptions were available for tax filers. That being said, this recent legislation has completely removed the possibility for claiming these exemptions until 2025.
With a dependent exemption, the IRS essentially allows the guardians of dependents to reduce their total taxable income by a specified amount. According to the IRS, a dependent is commonly defined as a relative who is unable to care for themselves.
Understanding Exemptions and Deductions
It is common for individuals to incorrectly equate exemptions to deductions. After all, both exemptions and deductions work to reduce the total tax burden of an individual. Unlike an exemption, however, which is directly associated with the specific individuals living within a household and their status as dependents, a deduction can be claimed for a variety of other circumstances, including charitable contributions, medical expenses and the federally allotted standard deduction available to every taxpayer.
Although the TCJA removed the opportunity to claim personal exemptions, the size of the standard deduction has been increased, helping to offset any potential losses.
Defining Tax Allowances
Allowances exist as a distinct entity compared to exemptions and deductions. When completing an employer-provided W-4, individuals have the opportunity to specify a number of situations that demonstrate their need to gain access to more of their paycheck prior to taxes. For example, individuals can claim allowances if they have dependent children in their care.
Unlike an exemption or deduction, an allowance does not reduce tax liability. Although an individual may not pay parts of their tax responsibilities with each paycheck, they will be required to settle this balance during filing season.
Exploring Allowances and Budgeting
Many individuals make the unfortunate mistake of claiming all allowances they are entitled to in order to gain access to a larger pool of discretionary income. The potential problem with this approach, however, lies in the fact that each allowance taken enlarges the size of a taxpayer's year-end tax bill. In some situations, individuals may discover that they are unable to pay their tax bill due to less than adequate budgeting throughout the year.
With this in mind, allowances should always be taken cautiously, and only with the necessary amount of planning involved. Failure to do so could create serious IRS-related issues when it comes time to file taxes.