What is withholding allowance and how does it work?

A withholding allowance is a tax-related exemption that impacts how much income tax an employer deducts from an employee's paycheck. This concept, once a staple in personal finance management in the United States, has undergone significant changes, particularly following the Tax Cuts and Jobs Act (TCJA) of 2017. This article delves into the intricacies of withholding allowances, their historical significance, and their current status.

A withholding allowance is essentially an exemption that reduces the amount of income tax deducted from an employee's paycheck. It was traditionally linked to personal exemptions, which were federal tax breaks available to all taxpayers regardless of their expenses until 2017. The more allowances an employee claimed, the less tax was withheld from their paycheck. Conversely, fewer allowances meant more tax was deducted.

The Impact of the Tax Cuts and Jobs Act of 2017

The TCJA brought about sweeping changes to the U.S. tax code, one of which was the elimination of personal exemptions from 2018 to 2025. As a result, the concept of withholding allowances lost its practical relevance. The IRS redesigned Form W-4, the Employee’s Withholding Certificate, which no longer includes withholding allowances. Instead, the form focuses on other factors like filing status, income, and tax credits to determine the correct withholding amount.

How Withholding Allowances Worked in the Past

Before the TCJA, employees would fill out Form W-4 upon being hired, indicating their personal information and the number of allowances they wished to claim. Employers used this information to calculate the amount of tax to withhold from each paycheck. The total number of allowances was crucial; claiming more allowances reduced the withheld tax, while fewer allowances increased it.

Determining Withholding Post-2017

Despite the elimination of personal exemptions, taxpayers still need to fill out Form W-4, which now considers other factors such as:

• Multiple jobs or a working spouse
• Eligibility for the Child Tax Credit
• Itemized deductions versus the standard deduction
• Additional income from sources like dividends or retirement

The IRS provides a Withholding Calculator to help individuals determine the appropriate withholding amount based on these factors.

Exemption from Withholding

Some individuals can claim complete exemption from withholding, but this status is challenging to obtain. To qualify, one must have received a full refund of all federal income tax withheld in the previous year due to no tax liability and expect the same for the current year. This exemption must be claimed annually by writing "Exempt" on Form W-4.

When to Redetermine Withholding

It's crucial to file a new Form W-4 whenever there is a change in personal or financial circumstances, such as marriage, the birth of a child, or a change in employment status. This ensures that the correct amount of tax is withheld, preventing unexpected tax bills or penalties at the end of the year.

Consequences of Incorrect Withholding

Incorrect withholding can lead to financial complications. If too little tax is withheld, you might owe money at tax time and possibly face penalties for underpayment. Conversely, if too much tax is withheld, you effectively provide the government with an interest-free loan, receiving your money back only after filing your tax return.

How Employers Calculate Withholding

Employers use the information provided on Form W-4 to calculate the withholding amount. They may use payroll software with built-in calculators or refer to IRS Publication 15-T, which outlines federal income tax withholding methods.

The Future of Withholding Allowances

The current state of withholding allowances could change in 2025 when the provisions of the TCJA expire. Until then, taxpayers need to navigate the revised system of tax withholding, ensuring they accurately complete Form W-4 to reflect their financial situation.

Understanding withholding allowances and the changes brought about by the TCJA is crucial for effective personal finance management. By accurately completing Form W-4 and staying informed about tax law changes, individuals can ensure they are neither overpaying nor underpaying their taxes throughout the year.