Income taxes weren't always withheld from people's paychecks. In fact, income tax withholding is a relatively recent development. Before 1943, taxes were only withheld in spurts when the government needed to raise extra revenue. This article will explain how we got the system that takes income taxes out of your paycheck and how that system works.

The Development of the Tax Withholding System
Tax withholding first occurred in 1862 under Abraham Lincoln for the purpose of helping to finance the Civil War. The federal government also implemented a plethora of excise taxes for the same purpose. But in 1872, not only was tax withholding abolished, but the income tax was repealed entirely.

After the ratification of the 16th Amendment in 1913, the income tax became permanent. The amendment was facilitated by the need to pay for World War I, and tax withholding was again implemented. However, withholding laws were repealed in 1917 because of employer complaints. Collecting income taxes from employees imposed a large burden on employers by placing them in the role of tax collector in addition to the role of businessman.

This time, it would be only 18 years before tax withholding resurfaced. After the Social Security Act passed in 1935, Social Security taxes were withheld by employers. This change paved the way for income taxes to be withheld again starting in 1943 with Congress' approval of the Current Tax Payment Act. Once again, war expenses were used as justification for tax withholding. As the early 20th-century writer and intellectual Randolph Bourne once noted, "War is the health of the state." Not only were taxes to be withheld again, but a massive tax hike was enacted. Income tax went from being a tax that was only paid by a few high-earning Americans to one that was paid by both the rich and the common man. The government wasn't sure it could successfully collect the higher taxes from its citizens without withholding at the source. (For more, read our Introduction To Social Security.)

The 1943 tax withholding system was developed in part by famous economist Milton Friedman, who then worked for the Tax Research Division of the Treasury. Originally a Keynesian economist who supported a large role for government in the economy, he later converted to the classical liberal mode of economic thought that decries government intervention, and he regretted his role in creating the tax withholding system. The system has stuck ever since, and some of today's retirees are the only ones who remember a time before tax withholding. (To learn more, see Free Market Maven: Milton Friedman.)

How Does Tax Withholding Work?
In the early days of the income tax, when there was no withholding, people paid their full income tax bills for the previous year once a year on March 15, or in quarterly installments. Under today's tax withholding system, taxes are collected at the source. This means that wage earners never see the money that they owe in taxes - it's taken by their employers out of their paychecks and transmitted directly to the federal government.

The amount of income tax that is withheld from each paycheck depends on how an employee fills out IRS form W4. This form is not submitted to the government - it is only used by the employee and the employer to determine how much tax to withhold. Form W4 includes a worksheet that taxpayers use to determine their withholdings, based on the number of jobs they hold, marital status and dependents.

It doesn't really matter how this form is filled out, as long as it results in at least 90% of the tax ultimately due in April being withheld from the employee's paychecks throughout the year. If less than 90% is withheld, taxpayers are subject to penalties and fines. Under the current withholding system, each April, people either pay the remainder of what they owe, or, if too much tax has been withheld, get a refund. Social Security and Medicare taxes are also withheld from every paycheck. (For more, check out How To Owe Nothing On Your Federal Tax Return.)

With today's system, only the wages earned by employees are subject to withholding (for the most part). There are many other ways of earning income, however. Independent contractors aren't subject to withholding, and neither is the income earned by investors. The 90% rule still applies, but individuals are responsible for calculating and remitting their own tax payments on a quarterly basis.

An exception to this rule arises if an individual becomes subject to backup withholding. If a taxpayer hasn't paid his taxes in the past, or the name and Social Security number s/he reported don't match, independent contractor and investment income (and some other uncommon categories of income) become subject to backup withholding at a rate of 28% (as of 2009). This situation is rare, though - most Americans are exempt from backup withholding.

The federal withholding system provides the model that 41 states use to withhold state income taxes - nine states: Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming don't have a state income tax. Some states use IRS Form W4, while others have their own withholding worksheets.

Form W4 doesn't give taxpayers a way to actually see how much income will be withheld from each paycheck. A good way to get a clear picture of how claiming different numbers of exemptions on form W4 will affect your income tax withholding is to use an online calculator.

To make sure you're having at least 90% of the tax owed withheld from your paychecks, and to make sure you aren't having too much withheld, use the tax withholding calculator at the IRS website. You can submit a new W4 to your employer to change your withholding at any time. (For more, read Common Tax Questions Answered.)

Most of us take the tax withholding system for granted, but it's not really a given. It has come and gone over the years with the government's desire to finance expensive projects and wars, and in response to the reactions of taxpayers to the system. Understanding how the system works will help you make informed decisions about both your political views and your personal finances.

For further reading, see Making Sense of the Tax Code.

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