What Is a Withholding Tax?

withholding tax is an amount that an employer withholds from employees' wages and pays directly to the government. 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.

Tax withholding first occurred in the United States in 1862 at the order of President Abraham Lincoln in order to help finance the Civil War. The federal government also implemented a plethora of excise taxes for the same purpose. After the Civil War in 1872, tax withholding and income tax were abolished entirely.

1:30

Withholding Tax

Understanding 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 collected 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. 

Payroll Taxes

The withholding tax is one of two types of payroll tax. The other type is paid to the government by the employer and is based on the employee's wages. 

Under the current system, the withholding tax is collected by employers and remitted directly to the government, with the employee paying the remainder when she files her tax return in April each year. If too much tax is withheld, that results in a tax refund. However, if not enough tax has been held back, the person will owe money to the IRS. 

U.S. Resident Withholding Taxes

Withholding taxes are 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 24%.

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. Seven states do not charge income tax and New Hampshire and Tennessee residents pay tax on dividends and income from investments

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.

How to Calculate Your Withholding Tax

Are you paying enough tax out of your paycheck? You can easily perform a paycheck checkup using the IRS withholding calculator. This tool helps identify the correct amount of tax withheld with each paycheck to make sure you don’t owe more in April. Using the calculator will require your most recent pay stubs, the most recent income tax return, your estimated income during the current year and other information.