What is – A Federal Withholding Allowance?

A Federal withholding allowance is the governments way of allowing you to adjust your taxable income, the basis for the federal tax withholding seen on your paycheck. Allowances are claimed on IRS Form W4, (it is one of the forms you must fill out when starting a new job). Some examples of federal allowances are:

  • Dependents you claim on your tax return (ie children)
  • If no one else can claim you as a dependent on their tax return
  • If you plan to file as head of household on your tax return

In the tax year 2011 each federal allowance claimed reduces your taxable income by $3,700.

Example:

Mark is a single male with no children and has a gross income of $50,000/year; he has no pre-tax deductions, making his taxable income also $50,000/year. A few months later Mark gets a new job and needs to fill out his W4, he realizes he was claiming no allowances before, (being just out of college when he filled out his first W4 he didn’t quite know what he was doing) and adjusts to claim 1 (no one else can claim him as a dependent on their tax return). This lowers Mark’s taxable income by $3,700 to $46,300, which also reduces his monthly federal tax withholding, boosting his monthly net income or take home pay.

An important note

You can claim as many allowances as you want on your W4, but this does not change the amount of federal tax owed in a given year. Claiming an allowance only lowers federal income tax withholding, come tax return time if you claimed ten allowances but only two actually apply (the government will check, so will any tax prep software) you will be stuck with a big fat tax bill, owing big Sam all that money which wasn’t withheld from your paycheck. On the contrary, if you receive a large refund you may want to consider increasing the number of allowances claimed, instead of waiting an entire year for that money you will receive a small piece of it every month because of reduced tax withholding.    

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What is – Taxable Income?

Taxable Income – The monetary base from which you are imposed a tax. Taxable income for the federal government is usually any income received over the course of the year (gross income) less deductions (such as a federal allowance or 401k contribution) and expenses as deemed allowable by the IRS. Taxable income at the state level is determined by the state’s taxing authority and can differ from the federal government and from state to state.

Simple example: John has a gross income of $50,000/year he contributes $5,000/year to his 401(k) retirement account and has claimed one federal allowance on his W4. In this case John’s taxable income would be $41,300.

Gross Income: $50,000

Less 401(k): $5,000

Less Allowance: $3,700

Taxable Income: $41,300 (this is the number you would use when referencing the IRS withholding tables to determine withholding)

Bottom line, taxable income is the number used to calculate the taxes you owe, whether it is to the federal, state, or local government.