What is 'Withholding Tax'
Withholding tax is income tax withheld from employees' wages and paid directly to the government by the employer, and the amount withheld is a credit against the income taxes the employee must pay during the year. It also is a tax levied on income (interest and dividends) from securities owned by a nonresident as well as other income paid to nonresidents of a country.
BREAKING DOWN 'Withholding Tax'
There are two different types of withholding taxes employed by the Internal Revenue Service (IRS) to ensure proper tax is withheld in different situations. The first and more commonly discussed is the withholding tax on personal income that must be done by every employer in the United States. The other form of withholding tax is levied against nonresidents of the United States to ensure proper taxes are made on income sources gained within the United States.
U.S. Resident Withholding Taxes
Withholding taxes is a way for the U.S. government to tax at the source of income, rather than trying to collect income tax after it is earned. This system was implemented in 1943 accompanied by a large tax hike. At the time it was thought that it would be difficult to collect taxes without collecting them from the source. Most employees are legislated and subject to withholding taxes when they are hired by filling out the IRS Form W-4. The form estimates the amount of taxes that will be due.
Generally you want about 90% of your estimated income taxes withheld by the government in this manner. It ensures you never fall behind on income taxes, which has some heavy penalties, but also ensures that you are not overtaxed throughout the year as well. Investors and independent contractors are exempt from withholding taxes but not from income tax. If these classes of taxpayers fall behind they can become liable to backup withholding, which is a higher rate of tax withholding set at 28%.
U.S. states may also have state income taxes and 41 states use withholding tax systems as well to ensure efficient tax collecting from residents. States use a combination of the IRS W-4 form or their own worksheets. Nine states do not charge income tax.
Nonresident Withholding Taxes
The same system of taxing income for nonresident aliens of the United States is employed to ensure effective and efficient tax collecting for the U.S. government. All nonresident citizens, who have not passed the green card test or a substantial presence test, must file Form 1040NR if they are engaged in a trade or business in the United States during the year. There are standard IRS deduction and exemption tables to help you figure out when you should be paying U.S. taxes and which deductions are possible to claim.
Withholding tax is necessary for the vast majority of people that earn income from a trade or business in the United States.