Who: This post is for people who enjoyed the first post on the Tax Basics and want to learn what allowances and exemptions are and how they work.
What: This is the second in a series of posts about income tax basics. This post will discuss what allowances and exemptions are and how income taxes are paid throughout the course of the year.

Disclaimer: I am not a tax accountant and only base my suggestions on my own readings and understandings of the tax laws. Follow the suggestions at your own risk, as I offer no warranty explicit or implied. You should always do your own homework before you read what some maniac writes on a blog on the Internet.

What is withholding?

As I mentioned in the first post of this mini-series, income taxes are paid throughout the course of the year. Using a very crude, simple and realistically inaccurate example, I will demonstrate. Please note that this example does not include things like the standard deduction and other adjustments to income that can be made. It is purposely oversimplified to explain the concepts of allowances and exemptions. For a more detailed explanation of the process, just review Uncle Sam’s Revenge Part 1: Tax Basics.

Samuel makes $60000 per year and his overall tax rate is 20%. This means that at the end of the year, he owes $12000 in taxes. We will assume that Samuel works a bizarre job and gets paid 20 times throughout the course of the year. This means that each paycheck is $3000 (60000 / 20 = 3000) before taxes. The federal government will withhold 20% of each of his paychecks (3000 * 20% = 600) every time he receives one. This means that Samuel pays $600 to the government and gets $2400 for himself on each paycheck. At the end of the year, after 20 paychecks, Samuel has paid $12000 in taxes (600 * 20 = 12000). Voila, Samuel has paid all of his taxes and he neither owes any taxes nor does he get a refund.

What is an exemption?

But alas, this example of perfectly calculated withholding rarely happens. As discussed in part 1 of this series, there are many adjustments to income that must be made before one can calculate the actual tax that needs to be paid to the government. The specific adjustments that I will discuss here are called exemptions. The general concept of an exemption, if you remember, is that they are “tax breaks” that you receive from the government if you have children, for example, that depend on your income. In other words, for each dependent you receive a set amount of money that you are allowed to deduct from your taxable income (and thus decrease your tax liability). In 2006, a single filer is allowed to deduct $3300 for each exemption that they claim. Let’s assume that Samuel has 3 dependents and see what this does to his tax situation.

Since Samuel has 3 dependents, each of whom afford him a $3300 deduction, he can subtract $9900 (3300 * 3 = 9900) from his $60000 to arrive at a taxable income of $50100 (let’s make it $50000 for simplicity). Now, we will also assume that Samuel’s overall tax percentage remains at 20%. With this change in his taxable income, Samuel will now only owe $10000 in taxes instead of $12000 (50000 * 20% = 10000). However since his paychecks and withholdings are still the same, he ends up paying the government $12000 over the course of the year when he actually only owes $10000. This means… you guessed it. A $2000 tax return.

What is an allowance? (Not the type parents pay their kids)

But what if Samuel needed that $2000 over the course of the year to feed his kids? Now we can talk about something called an allowance. Do you remember when you started your job and you had to fill out a W-4 form? Well, if you don’t remember, too bad (you did fill one out though). A W-4 form has various fields on it, but the one we will talk about is allowances claimed. Claiming an allowance allows you to increase the amount of your paycheck that you receive (in other words, decrease the amount that is withheld). In our example above, we assumed that Samuel claimed 0 allowances on his W-4 form. Roughly speaking, this means that taxes are deducted from his paycheck ASSUMING that he will claim 0 exemptions on his tax return. Let’s see what happens if Samuel decides to put 3 allowances on his tax return (one for each exemption he will claim).

Samuel still earns $60000. His taxable income is still $50000. Samuel’s overall tax percentage is still 20%. However, since Samuel has claimed 3 allowances, his paycheck withholding system will now know that he plans to claim 3 exemptions and that he does NOT actually have a taxable of $60000 but of $50000 instead. Now, since each of his paychecks is $3000, we assume only $2500 of it is taxable (50000 / 20 pay periods = 2500). So, Samuel’s withholding will be 20% of $2500, not 20% of $3000. As such, he will have $500 withheld on every paycheck (2500 * 20% = 500), instead of $600. At the end of the year, we see that Samuel has had $10000 withheld (500*20 = 10000). And voila, his withholding is back to the correct amount.

Tricky Tricky?

Now you know what an allowance is and how exemptions work! If you think about this for a little bit, you may figure out a money saving tip! If you can’t figure it out, don’t worry. I will soon post in Part 3 how to save some money using the information in this post! Hint: The Time Value of Money might be helpful.

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