What is the purpose of determining allowances on W4 Tax Forms?

Answer 1

Excellent question!

Imagine a time long ago where once per year the tax man would stop by and ask how much you made the previous year and then say "give me 25%". Oftentimes, you spend all you made and didn't have the 25% sitting around. The tax collector would often under collect the taxes by a large amount. So, the government got smart and said, "Why don't we collect taxes with every paycheck instead of waiting until the end of the year?"

Now, if you have a flat tax, this is easy. If your tax rate was 25% and there were no credits, deductions, or adjustments, the IRS would simply take 25% of your gross pay. In fact, they do this currently with social security (6.2%) and Medicare (1.45%).

But, we don't have a flat tax. Our tax structure is quite complicated. We enter all our income minus all our adjustments, deductions, exemptions (dependents) to get to our final taxable income which is taxed at a tiered rate from 10% to 35%. How much should your employer withhold and give to the IRS on your behalf every paycheck? 5%? 10%? 30%? Let's say you and a coworker both earn $50,000 per year, but he has a wife and 3 kids. Maybe his federal tax is only 5% of his earnings whereas you, single and no kids, has a federal tax of 15%. If your employer withholds 10% from each, your coworker will get a large refund and you will end up owing. He may want more in each paycheck and a smaller refund. You may want less in each paycheck and not owe anything at the end of the year.

Withholding allowances give you, the taxpayer, that control. They allow you to throttle the amount your employer withholds from each paycheck and gives to the IRS. There are limitations. If you choose an allowance that is too large, you may end up owing more than the IRS feels you should and they will charge you with penalties. On the other hand, if you choose a real small allowance, you will end up getting a much larger refund, but each paycheck may be not have enough post-tax money.

By the way, congratulations for calling them "withholding allowances" and not "dependents" or "exemptions". Most people don't know the difference.

Answer 2

By determining the number of allowances the IRS has made a reasonably informed guess at how much your tax liability is going to be based on the information you provide on the W-4. With that guess they have devised a number of charts and formulas to determine how much should be withheld from you income each pay period. If this was all done correctly your withholding each year should match your tax liability. It rarely works out exactly but that is the idea.