The Internal Revenue Service allows every person in the U.S. who files taxes to claim a personal exemption, which is the amount each individual taxpayer can deduct from gross income before calculating tax liability. In general, the more exemptions you claim, the more you can deduct from your income, thereby potentially reducing your tax liability. A personal exemption is a function of your filing status and number of dependents that you claim.
Personal Exemption
Every year, the IRS adjusts the personal exemption for inflation. In 2012, the personal exemption is $3,800 compared to $3,700 in 2011. You are entitled to claim a personal exemption for yourself and dependents who you support. For example, a married man with three children, can claim an exemption for himself and his children. His total exemption is this case in 2012 is $15,200, which is $3,800 x 4. He can also claim an exemption for his wife if she cannot claim her own personal exemption. You cannot claim a personal exemption if someone else can claim you as a dependent.
Advantage
The advantage of a personal exemption is that it reduces your taxable income. Therefore, the more exemptions you claim, the less income you have that is subject to tax. The IRS also allows you the option of taking a standard deduction or itemizing your deductions, which can further reduce your taxable income. The difference between a personal exemption and a deduction is that the personal exemption is a specified amount based on your filing status and deductions are actual expenses you incur throughout the year for such things as moving expenses and charitable contributions. If you itemize your deductions rather than take the standard deduction, your actual expenses exceeded the standard deduction allowance for your filing status.
Withholding Allowance
When you begin employment, you fill out an Employee's Withholding Allowance Certificate called a W-4. Your employer uses this form to deduct federal, state and local taxes from your paycheck. You're allowed an allowance for yourself and each of your dependents. The greater number of allowances you claim, the less money your employer withholds from your paycheck. The number of allowances you claim on your W-4 may or may not match the number of personal exemptions that you claim on your tax return. You can calculate the number of allowances to claim on the W-4 by using your standard deduction and personal exemptions.
Example
A single person claiming head of household may claim an exemption for herself and one for each of her dependents. In 2012, the standard deduction for head of household with two children is $8,500 + 2($3,800), which equals $16,100. In this case, she can claim four allowances on her W-4 based on $16,100 divided by her personal exemption amount of $3,800.
Insight
Claiming too many allowances leads to too little tax withheld from your paycheck, which leads to a tax liability, meaning you'll owe the money to the IRS. Claiming a personal exemption that you are not entitled to is tax evasion. While it is tempting to increase your personal exemptions to reduce your tax bill, you must offer proof to the IRS, and your information must match what the IRS has on file. Tax evasion is a serious offense which carries fines, penalties and could possibly lead to imprisonment.