Withholding Allowance: What Is It, and How Does It Work? (2024)

What Is a Withholding Allowance?

A withholding allowance is an exemption that reduces how much income tax an employer deducts from an employee’s paycheck and transmits to the IRS on their behalf.

This exemption from withholding is tied to the personal exemption, a federal tax break that was available to all taxpayers, regardless of their expenses, through 2017.

The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated personal exemptions for the period from 2018 to 2025. As a result, the withholding allowance has no current practical relevance. But that could change in 2025 when the TCJA changes end.

For now, it is no longer used on Form W-4: Employee’s Withholding Certificate, which the Internal Revenue Service (IRS) completely redesigned. Employees in the United States fill out and submit Form W-4 to their employers so that their employers know how much to withhold from workers' paychecks.

How Withholding Allowances Worked in the Past

Before 2018, an individual was required to fill out Form W-4 when hired by an employer. The form required certain personal information, such as their name and Social Security number and the number of allowances to be made.

The employer used the W-4 to determine how much of an employee’s pay to subtract from their paycheck so as to remit to the tax authorities. The total number of allowances claimed was important—the more tax allowances claimed, the less income tax would be withheld from a paycheck;the fewer allowances claimed, the moretax would be withheld.

The withholding amount was based on filing status—single or married but filing separately, married and filing jointly, or head of household—and the number of withholding allowances claimed on the W-4.

It was important to claim the right number of allowances to avoid trouble when filing taxes or to keep from giving the government an interest-free loan by paying too much in taxes (only to receive the amount back later as a refund).

How To Determine Withholding Post-2017

Much of how things worked before the passage of the TCJA is the same today. Individuals still fill out a W-4, employers still use it to calculate how much of an employee's paycheck should be taxed, and tax filing status is still key.

But the IRS revamped and simplified the W-4 form and how taxpayers should determine their withholding. Now, withholding amounts relate to whether an individual has multiple jobs or a spouse who works, what credits they can claim, and other adjustments.

For example, withholding is affected if:

• A taxpayer can claim the Child Tax Credit for a qualifying child (or a dependent who is not a qualifying child)
• They itemize personal deductions instead of claiming the standard deduction
• They have additional income from dividends, interest, or retirement income
• They or their spouse has more than one job
  

Exemption From Withholding

An individual can be completely exempt from withholding, but it’s not easy to receive that status. You can claim the exemption from withholding only if you had a right to a refund of all federal income tax withheld in the prior year because you didn’t have any tax liability and you expect the same for the current year. You simply write “Exempt” on Form W-4.

This must be done annually; the exemption doesn’t automatically carry over.

When To Redetermine Withholding

A new Form W-4must be filed with a taxpayer’s employer whenever the taxpayer's personal or financial situation changes(e.g., they get married, have a baby, or their spouse enters or leaves the workplace). The new withholding goes into effect no later than the first payroll period ending 30 days after giving the revised form to the employer. The employer may implement it sooner but isn’t required to do so.

It’s also possible to request that a specific dollar amount be withheld in addition to other tax withholdings. This may be helpful for taxpayers receiving a year-end bonus or for those who simply want to boost withholding near the end of the year (perhaps to cover taxes on investment income, such as capital gain distributions made at the end of the year). Individuals can also request that an additional amount be withheld with Form W-4.

What If Too Little Is Withheld?

The short answer: You are likely to owe money at tax time. And if you have significantly underpaid your taxes during the year, you may have to pay a penalty when you file your annual tax return. If you do not have enough withheld from your paycheck, you can request that your employer withhold an additional dollar sum.

If, on the other hand, you have more income withheld than you should, you will receive a refund after you file your annual income tax return. Receiving a refund isn’t necessarily a good thing—it represents money you could have used throughout the year to pay your bills or invest for your future financial well-being.

The Bottom Line

Ensuring that the right amount of money is withheld from each paycheck to pay federal income taxes is important. Employees who don't fill out Form W-4 carefully can get hit with a nasty tax bill out of the blue or essentially end up lending the IRS money free of charge.