Exemptions are calculated on an individual's U.S. Individual Income Tax Return, typically IRS Form 1040 or a simplified equivalent. In general, most taxpayers may claim an exemption for themselves, an exemption for a spouse and one exemption for each dependent. For most taxpayers, the number of exemptions claimed by the taxpayer directly reduces the amount of the taxpayer's taxable income. For higher income taxpayers, the tax value of exemptions is reduced and eventually eliminated for the highest income taxpayers.
Employers use the number of allowances an employee claims on Form W-4, along with the employee's income, to compute the amount of federal income tax that the employer must withhold from each paycheck the employee receives. The more allowances a taxpayer has filed, the smaller will be the amount of income tax withheld. Since the more exemptions a taxpayer can claim on his federal income tax return, the less tax withholding is necessary, then the number of allowances claimed on Form W-4 and the exemptions on the taxpayer's income tax return are strongly correlated.
In general, an employee may claim one allowance on Form W-4 for each exemption he is eligible to claim when filing Form 1040. However, in addition, an employee is able to claim additional exemptions for other tax beneficial items available to the employee. Employees eligible for a Child Tax Credit, Dependent Care Credit or with a certain income tax filing status are able to claim additional allowances beyond the number of exemptions so as not to have too much money withheld for taxes.
Form W-4 and its allowances only provide an estimate of the necessary federal income tax withholding. Employees with significant nonemployee income may find the withholding is insufficient to cover the entire federal individual income tax liability. Sources of nonemployee income include investment income and any self-employed business income. Taxpayers who find their employee withholding insufficient to cover income tax liabilities must file IRS Form 1040-ES and make additional estimated tax payments on a quarterly basis.