What is a 'Withholding'

A withholding is the portion of an employee's wages that is not included in his or her paycheck, but is instead remitted directly to the federal, state or local tax authorities. Withholding reduces the amount of tax employees must pay when they submit their annual tax returns. The amount withheld is based on the employee's income, marital status, number of dependents, and number of jobs.

BREAKING DOWN 'Withholding'

In the United States of America, all income earners are obligated to pay income tax to the federal government, and to some state governments. The tax collected is used to improve the state of the country and the wellbeing of its residents. In order to ensure that all residents working in the US are consistently paying their income taxes, the tax authorities require employers to withhold the tax from their employees' paychecks. The tax collected is then remitted to the Internal Revenue Service (IRS) on behalf of the wage earners.

An employee who starts a new job must fill out IRS Form W-4 which will be provided by the employer. The form has questions that the employee is required to answer truthfully. The employee has to indicate on the form whether he has one or multiple jobs. If s/he has multiple jobs, he has to disclose how much s/he is earning from the other job(s). The employee is also expected to divulge his or her marital status. If married, whether the spouse is unemployed and how much the spouse makes has to be disclosed on Form W-4. Other information to be included on the form include whether the employee has any dependents and if the employee be filing taxes as a head of household. The remaining section of the form is to be filled out by the employer.

Form W-4 provides the employee with information on how much the employer withheld as income tax. The employer uses the information provided by the employee as a guide on the amount of tax to be withheld from the employee’s pay. The employer figures out how much to withhold by factoring in the amount an employee earns and whether s/he wants any additional amount withheld. Any new event that unfolds in the employee’s life, such as change in marital status, an additional dependent, or new job, would require the employee to fill out a new W-4. The new information is used by the employer to re-evaluate the portion of income that is withheld for tax purposes.

If the tax withheld is inaccurate, the taxpayer may find himself paying more in income taxes or less than mandated. If at the end of the tax year, it is found that the employee paid more, the IRS will refund the excess to the employee as a tax refund. Workers who end up not paying enough tax on income earned may be subject to penalties and interest.

Workers who are self-employed aren't subject to withholding, but must make quarterly estimated tax payments instead. Taxpayers may also have to make estimated tax payments if they receive income in the form of dividends, capital gains, interest, or royalties.

Withholding is also carried out in retirement accounts. An individual who contributes to a retirement account has the option of either contributing after-tax dollars or before-tax dollars to the account. If taxes were not paid on the money that was contributed to the account, the individual will have taxes withheld when he withdraws funds from the account. For example, a Traditional IRA account holder does not need to pay capital gains tax on any growth within the account. However, any amount withdrawn after retirement will have a portion withheld as income tax. Withdrawals made from a 401k plan will have taxes withheld on the original contribution and on the earnings portion.

Taxpayers may also choose to have federal income tax withheld from their Social Security benefits. Form W-4V must be filled out by the individual and submitted to the Social Security Administrator (SSA) to authorize a percentage of the benefits to be withheld for income tax.