By Dan Miller, WCI Contributor

If you are a salaried employee, one of the first things that you will likely do when you are hired is fill out a W-4 form. While you can fill out a W-4 form at any time during your employment, many employees only fill it out once and never adjust it—even if their family and household situation changes.

Previously, you could specify a number of allowances on your W-4 which would correspond to the number of exemptions you expected to claim on your tax return. This would impact how much money was taken out of your paycheck for taxes each pay period. Even though allowances and exemptions are not a part of the current tax code, it can be useful to understand what they were and how they worked.

 

Defining Allowances: How They Work and What They Cover

Prior to 2020, allowances were used as part of filling out your W-4 form with your employer. A withholding allowance would let your employer know to not withhold as much tax from each of your paychecks. If you claimed zero allowances, your employer would withhold the maximum amount from your paycheck.

Your allowances roughly corresponded to the number of people for whom you were financially responsible. The logic was that every dependent would reduce your taxable income, causing you to have a lower tax burden when you filed your taxes. Claiming the right number of allowances on your W-4 form would increase the chances that you ended up with the right amount of money withheld.

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Understanding Exemptions: Reducing Your Taxable Income

A tax exemption is a way to reduce your overall taxable income. A tax exemption is similar to a tax deduction but generally comes with fewer hurdles in claiming it. Prior to tax year 2019, nearly every taxpayer received a personal exemption for themselves and their dependents. However, the Tax Cuts and Jobs Act (TJCA) that was passed at the end of 2017 simplified much of the tax code and eliminated this personal exemption.

When the personal exemption was part of the tax code, there was a correlation between the number of allowances you claimed on your W-4 with your employer and the exemptions you would claim on your tax return. Claiming more allowances than exemptions might mean that you would owe taxes and/or penalties when you filed the return. Conversely, having fewer allowances than exemptions might set you up for a big refund at the expense of giving the government an interest-free loan all year.

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Key Differences Between Allowances and Exemptions

While allowances and exemptions share a fair number of similarities, there is one key difference that you should know. Allowances were something entered on the W-4 form given to your employer, and they determined how much federal tax your employer would withhold from your paycheck.

Tax exemptions are similar to tax deductions in that they lower your overall taxable income.

 

Strategies for Using Allowances and Exemptions

While allowances are no longer on the W-4 form and the personal exemption is no longer a part of the tax code, the principles of filling out your W-4 are still valid. In most cases, it makes good financial sense to try and match the amount of tax you have withheld from your paycheck with the amount of tax that you have due when you file your tax return in April.

Now, instead of setting the number of allowances on your W-4, you can use the IRS's online estimator app or manually enter in deductions (such as for the number of dependent children you have) for any other income you will receive during the year or an additional amount to have withheld from your paycheck.

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The Bottom Line

Allowances and exemptions are both tax terms that were more relevant in previous iterations of the US tax code. You could claim a certain number of allowances on the W-4 form that you filled out with your employer. These would roughly correlate to the number of dependents that you planned to claim on your annual tax return. Allowances are no longer mentioned on the W-4 form, and while there are still tax exemptions, there is no longer a personal exemption that you'll claim on your 1040 form.

However, it does still make sense to try to fill out your W-4 in such a way that the total amount of tax that you have withheld from your paycheck is close to the amount that you'll owe at the end of the year.

 

If you need help with tax preparation or you’re looking for tips on the best tax strategies, hire a WCI-vetted professional to help you figure it out.

 

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