When you start a job, you give your employer the W-4 form which figures out your allowances (or deductions). It's just a number. How does that translate into how much they withhold from your paycheck?
For example, if I put 1 through 10 in that box, how much difference would that be for someone making $60,000 annually.
The translation scheme is detailed in IRS Publication 15, "Employer's Tax Guide". For the 2010 version, the information is in Section 16 on Page 37. There are two ways that employers can calculate the withheld tax amount: wage bracket and percentage. Alternatively, they can also use one of the methods defined in IRS Publication 15-A.
I'll assume the person making $60k/yr with 10 allowances is paid monthly ($5000/period) and married. Using the wage bracket method, the amount withheld for federal taxes would be $83 per pay period. Using the percentage method, it would be $81.23 per pay period.
I don't recommend that you use this information to determine how to fill out your W-4. The IRS provides a special online calculator for that purpose, which I have always found quite accurate.
Note: "allowances" are not the same as "dependents"; "allowances" are a more realistic estimation of your tax deductions, taking into consideration much more than just your dependents.
A simplistic answer would be that it's a multiplier on how much money per paycheck to subtract from your tax withholding (taxes per paycheck), then at the end of the year you will have paid taxes on your income minus the amount of your withholding allowances.
If you get a decent (roughly 3% or more of your gross annual salary) refund you are letting the government withhold too much (and should increase your allowances), if you have to pay a decent amount of taxes at the end of the year then the amount withheld is not high enough (and should decrease your allowances).
I definitely recommend using the calculator that Stephen Cleary mentions, but I think it's just as easy to adjust it up or down by 1 or 2 each year based on whether you got a large refund, no refund, or paid taxes.
If you are disciplined with your money many experts advise to increase withholding allowances, save the extra in a safe short term interest account so that you earn money on your money and not the government.
I've given up on trying to understand how the allowances correspond to my number of dependents. What I do instead to achieve the same end goal of having the right amount of money withheld is using a paycheck calculator.
If I get paid 24 times a year (twice a month) and I figure I'm going to owe about $6,000 of taxes, then every paycheck needs to have $250 of federal tax withheld from it to make sure I am covered.
Go to the paycheck calculator and play with the allowance numbers until you get $250 as the federal tax withheld and then submit a new W4 to your employer.
This is the only reliable way I've found to figure this out on my own. Because my calculations are done in dollars instead of exemptions, etc. and my taxes do not wildly fluctuate year-to-year this works well for me.
The taxes that are deducted from you paycheck are estimated from the expected annual income you receive from the employer. In the same way, the employer will deduct from that expected annual income the tax deductions you would get for the number of dependents you specify. Hence your net income will be lower, your annual tax obligation also, which can than be calculated down to the period of your paycheck.
Allowances are calculated as your total deductions divided by the tax year's personal exemptions. As mentioned above it is a multiplier.
For 2015 the standard deduction for a married couple filing jointly is $12,600 and each of you gets 1 personal exemption ($4,000 in 2015). That's a total of $12,600 + 2*($4,000) or $20,600. Divide this by the personal exemption and you get roughly 5 allowances.
Now say your employer offers health insurance and a 401(k) plan. Your total health insurance (or "cafeteria" contributions) are $2,000 for the year, and your total 401(k) plan contributions are $6,000 for the year. This would give an additional $2,000 + $6,000 = $8,000 divided by $4,000 = 2 allowances. Thus you would file with 7 allowances.
Note that tax credits are not included in the allowance calculation. That is because they do not affect your taxable income but rather directly reduce your taxes due.
