Your employer uses the withholding allowances you claim on your W-4 form to adjust your gross pay before calculating how much federal income tax to withhold from your paycheck. The idea is to withhold enough tax each pay period so that you will have already paid all or most of the tax you owe at the end of the year. If you want to add an additional allowance, it can make a difference in the amount of your paycheck that is subject to withholding.
Defining a Withholding Allowance
A withholding allowance is a sum of money subtracted from your gross pay to figure your taxable earnings for federal income tax withholding. The size of a withholding allowance depends on the length of your pay period and is derived from an annual basis amount that is equal to the amount of one personal exemption. For example, in 2017 the annual basis was $4,o50, while in 2018 the annual basis is $4,150. To figure the size of a withholding allowance, divide the basis by the number of pay periods. If you were paid weekly in 2018, divide $4,150 by 52 for a withholding allowance of $79.81.
Your employer subtracts allowances from your gross pay to figure your taxable earnings for federal income tax withholding. Each withholding allowance you claim reduces your taxable earnings and therefore the amount of tax withheld. You can have additional amounts subtracted from gross pay when calculating taxable earnings. These amounts might include contributions to a tax-deferred retirement plan, for example. Taxable earnings are used only to figure federal income tax withholding. Social Security and Medicare taxes are computed using your gross pay, so allowances don’t affect them.
The difference in the amount of federal income tax withheld when you claim an additional allowance depends on which tax bracket you are in. Your tax bracket is the highest percentage tax rate applied to your taxable earnings. Suppose your filing status is single, you are paid weekly and your taxable earnings one week come to $1,500. In 2018 this put you in the 22 percent tax bracket, which encompasses annual taxable income of between $38,700.01 and $82,500.00. One withholding allowance was equal to $79.80. If you add a withholding allowance, this decreases taxable earnings by $79.80. The difference made by that withholding allowance was 25 percent of $73.15, or $17.56.
Occasionally a withholding allowance overlaps two tax brackets. Suppose your taxable earnings were $1,700 in the above example, and you change your W-4 form to add one allowance because you have a new baby. Your taxable earnings decrease by the amount of one allowance to $1,620.20. This example overlaps the 25 percent bracket and the 28 percent bracket. To figure out the difference in tax withheld, figure the tax on the portion of the allowance in each tax bracket and add them together. First, multiply $61.15 ($1,688 minus $1,626.85) by 25 percent to get $15.29. Next multiply $12 (the difference in income between the lower and higher tax brackets) by 28 percent to get $3.36. The difference made by the withholding allowance comes to $18.65.