One of the many documents you have to fill out when you start a job is a Form W-4, which tells your employer how many allowances you're claiming for income tax purposes. Entering the proper number of allowances helps avoid having to write a big check to Uncle Sam when you file your taxes.
Effect of Allowance
Claiming allowances reduces the amount of money your employer withholds from your paycheck to cover your income taxes due at the end of the year. When you claim one allowance, it reduces your income subject to tax withholding by the value of one allowance over the course of the year -- $3,900, as of 2013. For example, if you're paid weekly, each allowance reduces your paycheck subject to withholding by $75.
Effect on Refund
The amount withheld from your check doesn't affect your actual tax liability, just how much of it is covered through withholding. When you get a refund, it doesn't mean the government's paying you -- it usually just means you're getting back the extra money you paid in during the year. Let's say your tax liability is $3,500. If you have $2,900 withheld, you're left with a bill of $600. However, if you had $4,000 withheld, you'll get a $500 refund.
Reasons for Owing More
The withholding from your paycheck only includes the income you make from that job. If you have more than one job, or other sources of income that aren't subject to withholding, you could find yourself owing extra money. Let's say that besides the $40,000 you earn from your job, you made a $5,000 profit on stocks you sold during the year. While you're only claiming one allowance, you might owe more taxes because of the capital gains.
Reasons for Refund
If you're entitled to more than one allowance and only claim one, you'll probably have a refund coming. You may be entitled to multiple allowances if you're claiming dependents on your tax return, filing as head of household, claiming dependent care expenses or claiming other large deductions and credits (besides the standard deduction). For example, if you qualify for a large earned income credit, that will reduce your tax liability and increase your refund.
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