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Updated on Monday, February 22, 2021
Before changes to the tax system went into place in 2020, one of the most significant factors impacting your paycheck was the number of tax allowances you claimed on your W-4 form. By claiming multiple allowances, you could reduce how much of your paycheck was withheld for federal income taxes.
However, all that changed with the passage of the Tax Cuts and Jobs Act (TCJA) in late 2017. Here’s what you need to know about the old tax allowance system, and how federal income tax withholdings are handled now.
- Tax allowance definition: What was it, and how did it work?
- Withholding tax definition: What is it and how does it work?
- How to calculate your tax withholding
- How to change your tax withholding
- Withholding tax exemption
Tax allowance definition: What was it, and how did it work?
Prior to the 2019 tax year, tax allowances were incredibly important. By adjusting your tax allowances on your W-4, you could have more money withheld from your paycheck for taxes — or put more money in your pocket.
When you work for an employer, you’re legally required to fill out a W-4; based off of the W-4, your employer withholds a certain amount of your paycheck every pay period to cover your tax bill. Previously, tax withholding allowances functioned as exemptions. For each tax allowance you claimed, less money would be taken out of your paycheck to cover your taxes. If you claimed zero allowances, your employer would withhold the maximum amount for taxes. The more allowances claimed, the less would be withheld for taxes.
When you filled out your W-4 form, you could complete the personal allowances worksheet. This worksheet would prompt you to enter “1” for every allowance that applied to you. For example, you could enter “1” for yourself and your spouse, giving you a total of two allowances. If you had a child, you could enter yet another “1” for a total of three allowances, and so on.
The Tax Cuts and Jobs Act and tax allowances on the W-4
The TCJA changed tax allowances on the W-4. The goal of the TCJA was to reform the tax system, simplify taxes and streamline the W-4 form for 2020.
Tax allowances are no longer used on the W-4, and with the changes to the law, you can’t claim personal deductions or dependency exemptions. The form now features just a few basic questions about your tax filing status and dependents to calculate your withholding.
Per the IRS rules, any adjustments made to your withholdings on or after Jan. 1, 2020, must be made with the new W-4.
Withholding tax definition: What is it and how does it work?
The federal income tax system requires you to pay as you go, meaning you must pay taxes as you receive income during the year.
Federal withholding tax is how much your employer withholds from each of your paychecks and pays to the IRS on your behalf. To determine how much to take out of your paycheck for federal income taxes, employers must have employees complete W-4 forms.
An accurate W-4 is essential. If you’re withholding too little, you could pay less federal income taxes than is required, leaving you with a hefty bill at tax time and underpayment penalties. If you withhold too much, more money is taken out of your paycheck than is necessary. You can get the money back as a refund when you file your tax return, but it may be better to adjust your withholding so you can get that money in every paycheck. (Here’s why you should not use your tax refund as forced savings.)
How to calculate your tax withholding
If you received a large tax refund last year, you’re likely withholding more than is necessary from your paycheck for taxes. If you’d like to have access to that money during the year rather than getting a lump sum refund after filing your taxes, you can change your withholdings so less is taken out of each paycheck.
If you need to change your tax withholding, you can check your withholding for 2021 by using the IRS Tax Withholding Estimator tool. Common circumstances that would cause you to change your withholding include:
To use the Tax Withholding Estimator tool, follow these steps:
- Gather information: To use the tool, you’ll need the most recent pay stubs for yourself and your spouse, if applicable. You’ll also need information for other sources of income, such as investments, as well as last year’s tax return.
- Answer Questions: The tool will ask you questions about your tax filing status, your dependents, your expected income and the frequency with which your employer pays you, as well as if you contribute to an employer-sponsored retirement plan, Health Savings Account or Flexible Spending Account. You’ll input how much in federal taxes you’ve paid so far and how much is taken out of each paycheck.
- Review results: Based on the information you entered, the Tax Withholding Estimator will tell you your anticipated tax obligation and how much you’re currently withholding. If you’re overpaying, it’ll give you a total of just how much you’ve overpaid. It’ll also tell you how much should be withheld from each paycheck to meet your obligation.
- Complete a new W-4: If you decide to change your withholding, you must complete a new W-4 form. When filling out the form, use the Tax Withholding Estimator to find out how much you should enter on the form for credits and other reductions to annual withholding. Sign and date the form, and give it to your employer.
How to change your tax withholding
Now that tax allowances are no longer an option, you’ll need to complete the new W-4: Employee’s Withholding Certificate. To do so, follow these steps:
- Step One: The first section of the W-4 asks for your personal information, including your name, Social Security number, address and filing status.
- Step Two: Not everyone will need to complete this second section, Multiple Jobs or Spouse Works. If you only have one source of income or a non-working spouse, you can skip this section — otherwise, you’ll need to complete a W-4 for every job you have.
- Step Three: For the Claim Dependents section, your income needs to be $200,000 or less ($400,000 or less if married filing jointly). Multiply the number of children you have under the age of 17 by $2,000 and enter the resulting number on the line. If you have other dependents, multiply the number of dependents you have by $500.
- Step Four: An option step, this portion is for other adjustments, such as retirement income or interest earned. If you want to withhold additional money from your paycheck, you can also include the added amount here.
Withholding tax exemption
If you’re exempt from tax withholding, you don’t make any federal tax payments throughout the year from your paycheck. Since that can sound appealing, you may be wondering: “Am I exempt from tax withholding?”
To qualify for a withholding tax exemption, both of the following need to be accurate:
- You owed no federal income taxes in the prior tax year
- You expect to owe no federal income taxes in the current tax year
If you aren’t sure if you’re exempt from withholding or otherwise need help managing your taxes, contact a tax professional for assistance.