Withholding: Definition, Tax Rules, Federal vs. State

What Is Withholding?

Withholding is the portion of an employee's wages that is not included in their 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 employee's income, marital status, number of dependents, and number of jobs all determine the amount withheld.

Understanding Withholding

In the United States, all income earners are obligated to pay income tax to the federal government and some state governments. The tax collected is used to improve the state of the country and the well-being of its residents.

Tax authorities require employers to withhold the tax from their employees' paychecks to ensure that all residents working in the U.S. are consistently paying their income taxes. Employers remit the tax collected to the Internal Revenue Service (IRS) on behalf of the wage earners.

Form W-4

An employee who starts a new job must fill out IRS Form W-4, which the employer typically provides. The form has questions that the employee is required to answer truthfully. For example, the employee must indicate whether they have one or multiple jobs. If they have multiple jobs, they must disclose how much is earned from the other job(s).

The employee is also expected to divulge their marital status. If married, whether the spouse is unemployed and how much the spouse makes has to be disclosed on Form W-4.

Form W-4 also includes questions about dependents and filing status, such 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 withhold from the employee’s pay.

The employer figures out how much to withhold by factoring in the amount an employee earns and whether they want any additional amount withheld. Any new event that unfolds in the employee’s life, such as a change in marital status, an additional dependent, or a new job, would require the employee to fill out a new W-4. The employer uses the new information to re-evaluate the portion of income to withhold for tax purposes.

Special Considerations

If the tax withheld is inaccurate, the taxpayer may pay 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.

Self-employed workers aren't subject to withholding but must pay their income taxes, usually as quarterly estimated tax payments. Taxpayers may also have to make estimated tax payments if they receive income in the form of dividends, capital gains, interest, or royalties.

Federal Withholding vs. State Withholding

Withholding is generally classified as federal withholding or state withholding. What you are required to pay to the federal government differs from what you are required to pay to your state.

Federal withholding is the amount withheld from wages for taxes owed to the federal government. The amount of withholding is based on filing status, the number of dependents, certain adjustments to income, and other personal withholding preferences selected on form W-4.

Wage-earners can also elect to have a specific amount withheld in addition to what's calculated from elections. Alternatively, they can also elect to have nothing withheld by claiming an exemption.

Federal withholding also includes amounts automatically withheld for Social Security and Medicare. The employee and employer are responsible for paying an equal share of these taxes. From the employees' pay, 6.2% is withheld for Social Security and 1.45% for Medicare. The employer must also pay a total of 7.65% for these taxes.

State withholding is the amount withheld from wages for taxes owed to the taxpayer's state of residence. In some cases, the taxpayer may owe taxes to multiple states. For instance, if a remote worker splits their time between two residences in different states, they may owe taxes to each state. It may be possible for an employer to withhold taxes for each state.

State taxes can only be withheld if federal taxes are withheld. Thirteen states and Washington D.C. require mandatory state withholding when federal taxes are withheld. Nine states have no state tax withholding, and the rest are elective.

Other Types of Withholding

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 would have taxes withheld when withdrawing 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 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 and submitted to the Social Security Administrator (SSA) to authorize the withholding of a percentage of the benefits for income tax.

The Bottom Line

Withholding is the amount deducted from wages for taxes: federal, state, or local. Wage-earners in the U.S. are required to pay federal taxes and state taxes. If enough taxes are withheld, the taxpayer may receive a tax refund. If withholding is insufficient, the taxpayer is obligated to pay their remaining tax obligation.

Employees must complete a form W-4 to designate what should be withheld for taxes based on their personal situation. The IRS provides a tax withholding estimator taxpayers can use to estimate how much they should withhold or if what they are withholding is adequate.