The idea behind payroll tax withholding is to place paying your taxes on a “pay as you go” basis. Your employer deducts taxes each payday and sends the money to the Internal Revenue Service. As a result, when it comes time to file your tax return, all or most of your tax liability is already paid. Your employer uses the withholding allowances you claim on your W-4 form to determine the correct amount of income tax to take out of your paycheck.
A withholding allowance is based on an annual amount that is adjusted each year to compensate for inflation. For instance, in 2012 the basis amount for withholding allowances was increased to $3,800 from the 2011 level of $3,700. The annual basis for withholding allowances parallels the amount of the personal exemption you claim on your tax return. The idea is to reduce the amount of your pay that is used to calculate federal income tax withholding by an amount comparable to the reduction of your taxable income on your tax return due to the personal exemptions you claim. You can claim fewer withholding allowances on the W-4 form you complete and give your employer than you are entitled to, but you can’t claim more.
The amount of one withholding allowance depends on the length of the pay period where you work. To calculate how much a withholding allowance is, divide the annual basis amount by the number of pay periods per year. For example, if you are paid every two weeks, for 2012 you would divide $3,800 by 26 for a withholding allowance of $146.15. Your employer subtracts this amount for each withholding allowance you claim from your gross pay before calculating income taxes.
Withholding allowances are used to claim exemptions for yourself, your spouse and your dependents. You can also claim extra withholding allowances if you have only one job or when you can file as head of household. You may be able to claim more withholding allowances if you expect to qualify for the Child Tax Credit or Child and Dependent Care Credit. The more allowances you claim, the smaller the amount of tax taken out of each paycheck.
The information you provide on your W-4 form only allows your employer to estimate the amount of tax to withhold. You may have a second job, investment earnings or self-employment income. Any of these sources of income can increase the amount of your tax liability at the end of the year. You may choose to claim fewer allowances or ask for extra tax to be withheld to avoid a large tax bill when you file your taxes. You may also complete and submit a new W-4 form anytime an event changes your situation. For example, you might submit a new W-4 when a baby is born so you can claim one or more additional withholding allowances.