Ultimately, there is very little difference between state and federal withholding taxes. The chief distinction is that state withholding is based on state-level taxable income and federal withholding uses federal taxable dollars. State withholding rules tend to vary among the states, while federal withholding rules are consistent everywhere throughout the United States.

How Withholding Works

Both state and local governments may impose withholding on wage income, but only based on the state taxes; they may not withhold federal income taxes.

Employers can be required to automatically deduct withholding from their employees' paychecks for federal and state income taxes and Social Security taxes. Individual taxpayers may elect to withhold additional taxes from their paychecks, annuity checks or other forms of income.

Examining Withholding Taxes

The modern tax withholding system was introduced in the 1940s as a response to funding needs for military operations during World War II. It expedited the tax collection process; it also made it much easier for governments to raise additional taxes without taxpayers being made aware of it.

Before the withholding system was put into place, income taxes were due at a certain time of year (originally in March) and taxpayers had to pay, in full, on that date. This made them keenly aware of their individual tax burden. Through withholding, taxpayers have their taxes automatically deducted throughout the year, so they might not be as likely to feel the bite.

For most Americans, every paycheck has a line titled "federal taxes withheld" and "state taxes withheld." If you earn $1,000 in a paycheck but the government withholds $250, you only get to take home $750. If, by tax day, you had more money withheld than you should have paid in taxes, then the government sends you a tax refund.