Withholding, Exemptions, Deductions, Oh My!
Remember when you hired in at your job, and they made you fill out a W-4 (https://www.irs.gov/pub/irs-pdf/fw4.pdf) and probably some other forms? You may have filled it out and thought nothing of it, or it may have been so long ago, you don't remember. The worksheet can be misleading and not helpful without an understanding of what it is doing. And an employer technically isn't supposed to give you any help on it. But I can!
This form tells your employer how much federal income tax to withhold from your pay, based on the number of allowances you calculate. Withholding is important because at the end of the year, your income versus how much tax you had withheld is how your tax refund or what you owe is calculated.
Some background: Every person gets an exemption amount for tax purposes - for 2016, that number is $4,050. And wherever that person goes on a tax return, the exemption follows. So if you are filing your own return, you get $4,050 deducted from your income to calculate your tax. If you are a dependent of a parent, for example, your exemption goes on their return. If you claim a child or other dependent, you get their exemption on your tax return. The worksheet helps taking into account the number of exemptions you plan to claim on your tax return.
Every person also gets a standard deduction of $6,300 on their return (Married Filing Jointly is double at $12,600, Head of Household $9,300). If your itemized deductions go over those standard deductions, you end up itemizing (things like real estate taxes, state and local tax withheld, mortgage interest, charitable contributions, etc). The worksheet helps take your standard or itemized deduction into consideration, as well as any child tax credits and child or dependent care expenses.
What the W-4 tells your employer is how many exemptions and what deduction amounts you expect to claim on your tax return.
If you were to fill out the W-4 with zero allowances, your employer is going to withhold the full amount of tax expected to be calculated on your tax return, based on your income alone and not considering any exemptions or deductions (this is good if you are claimed on someone else's return so that you won't owe). You generally can't go wrong claiming zero allowances (exception would be if you have other untaxed income during the year in addition to your regular W-2 income), and you can expect a refund at the end of the year.
However, if you have a spouse and two children, that would mean your employer is withholding the maximum tax and you'll end up with a large refund at the end of the year. Why not just get that money spread out over each paycheck? In that case, the allowance worksheet will help you calculate how many allowances to claim. And your employer will withhold less tax, accounting for the 4 exemptions and deductions you'd subtract on your tax return.
My general rule is to claim the number of allowances that will match the number of exemptions on your return. I'm single with no dependents - I always claim one allowance and have never owed on my W-2 income (though I also have always calculated a loss on my 1099-MISC income due to the amount of driving it has required). I could probably claim 2 to be at a more breakeven point, but I'd rather not run the risk of owing at the end of the year, depending on my other sources of income. Also if you live in Michigan, the state tax return doesn't take into consideration your standard or itemized deduction, only number of exemptions, so I have seen some people owe after claiming 2 allowances.
You can fill out a new W-4 at any time. In the form instructions, it says to consider completing a new form each year and when your personal or financial situation changes. So if you owe for the 2016 tax year due to not enough tax being withheld from your checks, my advice is to go complete a new one for 2017!
Cheers and Happy Filing!