What Is a Retention Tax?

A retention tax is a tax withheld at the source, that is, by the employer. Payroll tax withholding is one common example of a retention tax. Employers divert a portion of an employee’s paycheck to the IRS to cover anticipated taxes. Employers also retain taxes owed by overseas employees to ensure that the IRS receives the taxes before the money leaves U.S. borders.

Key Takeaways

  • A retention tax is any tax that an employer deducts from an employee’s paycheck and pays directly to the government.
  • Payroll tax is one of the most common forms of retention tax.
  • The Employee Retention Credit allows eligible employers to claim a refundable tax credit against the employer share of Social Security tax equal to 70% of the qualified wages they pay to employees after December 31, 2020, through June 30, 2021.

Understanding the Retention Tax

A retention tax is any 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 that will 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 is 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%. 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.

Special Considerations

The Coronavirus Aid, Relief, and Economic Security (CARES) Act introduced a piece of legislation called the Employee Retention Credit. This credit allowed eligible employers to reduce a portion of the employment tax deposits they withheld and are otherwise required to make. It was used as an incentive for employers to keep employees on payroll during the pandemic.

The credit was later extended and amended when Congress passed the Taxpayer Certainty and Disaster Tax Relief Act of 2020, which was enacted December 27, 2020. The new version of the credit allows eligible employers to claim a refundable tax credit against the employer share of Social Security tax equal to 70% of the qualified wages they pay to employees after December 31, 2020, through June 30, 2021. Qualified wages are limited to $10,000 per employee per calendar quarter in 2021. Thus, the maximum ERC amount available is $7,000 per employee per calendar quarter, for a total of $14,000 in 2021.