The progressive tax system in the U.S. taxes people at higher rates as their income increases. Fortunately, not all of your income is subject to taxes, as the tax code has set up certain expenses that you can deduct from your taxable income. You can adjust how much of your salary from an employer is withheld to cover taxes by modifying your withholding allowances. Both your tax deductions, and your withholding allowances, are subject to some limitations.
The U.S. tax code sets up many legal deductions that can be taken from your taxable income, as incentives for certain types of behavior. For example, a deduction for home mortgage interest is designed to encourage people to buy and maintain a home, by offsetting some of the cost of the interest on a home mortgage. While there is no limit on the number of deductions you can claim, some deductions are limited by factors such as your income, the level of the expense or other qualifying criteria. The home mortgage interest deduction, for example, can be claimed for mortgage debt up to $1 million.
Itemized vs. Standard Deductions - Limitations
If you claim the standard deduction on your income tax return, which is $11,900 for a married couple filing jointly for the 2012 tax year, you cannot claim itemized deductions, such as home mortgage interest, property taxes or medical expenses. You should calculate your itemized deductions, and if the amount of your itemized deductions is greater than your standard deduction, go ahead and itemize to maximize your tax savings.
Documenting Your Deductions
The IRS will sometimes examine or audit a taxpayer's income tax return to verify that you are legally entitled to the deductions that you have claimed. To prove the validity of these deductions, you must keep accurate financial records, including receipts to prove you have incurred a deductible expense. Some expenses may also be validated by bank statements, and tax forms that lenders or other institutions send to you. You should keep tax-related receipts documenting deductions for at least three years from the due date of the tax return.
Your employer calculates how much to withhold from your paycheck based on the amount of withholding allowances you claim on your Form W-4. This is a form that you file with your employer's payroll department, usually when you start a new job. You can update your W-4 any time you have an event that potentially changes the amount of taxes that you will be liable for. An example would be if you have a new baby, or if a child leaves home and is no longer eligible to be claimed as an exemption. You may also increase your withholding allowances if you anticipate a larger number of tax deductions. By increasing the number of allowances, you reduce the amount of money withheld for income tax.
High Numbers of Withholding Allowances
While you are not limited to any specific number of withholding allowances, you want to avoid claiming so many that you owe more money than you can pay come tax time. In this case, you could end up owing a penalty for underpayment of taxes. Also, if the IRS suspects you are claiming too many allowances, which will result in an underpayment of your taxes, it may force you to claim fewer allowances. The IRS uses information in its own records, as well as W-2 information from pay records to make this determination.