What is a 'Retention Tax'

Retention tax refers to a tax withheld at the source, that is, the employer. It is common practice for an employer to divert a portion of an employee’s paycheck to the IRS to cover anticipated taxes. Employers also retain taxes owed by overseas employees to help ensure that the IRS receives the taxes before the money leaves U.S. borders.

BREAKING DOWN 'Retention Tax'

A retention tax is a tax that an employer deducts from an employee’s paycheck and pays directly to the government. This commonly takes place for two reasons. The first form of withholding is common for all employees expecting to owe taxes over the course of a tax year. Taxpayers complete a W-4 form and provide the employer with a list of withholding allowances which will each reduce the tax retained by the employer. Withholding allowances include:

  • Two-income families.
  • Dependents who qualify for the Child Tax Credit.
  • Dependents over the age of 17.
  • Itemized deductions in previous years.
  • Large tax refunds or bills in previous years.

An employee who does not submit a W-4 form will be treated as an unmarried person with no allowances and thus subject to the highest possible withholding rate. W-4 forms can be updated whenever a taxpayer undergoes a significant change in allowances. Taxpayers who have reason to expect zero tax liability at the end of the tax year can claim exemption from withholding.

Retention Tax for Foreign Nationals

The second type of retention tax is that which employers retain from the paychecks of foreign nationals working in the United States. Foreign nationals are generally subject to a federal withholding rate of 30 percent. Exceptions to this rule include foreign nationals of countries that have specific tax treaties with the U.S., such as Canada and Japan.

Whatever the reason for a tax withholding, the amount retained is an estimate of those taxes that the employee will owe at the end of the tax year. Allowances are meant to be a good faith attempt at adjusting the withheld amounts to better reflect the year-end obligation. Taxpayers often receive a refund or are obligated to make a year-end payment to reconcile withholding with their actual year-end tax bill.

In rare cases, firms that pay dividends or interest on investments are required to retain backup withholding on payments to individuals who have not provided a tax identification number or who are of special interest to the IRS.  Employers must make quarterly reports of withheld taxes to the IRS via form 941, also known as the Employer’s Quarterly Federal Tax Return. The IRS sometimes refers to employers withholding taxes as withholding agents in official documents.

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