What Is Withholding Tax?
Withholding tax is the money an employer deducts from an employee’s gross wages and pays directly to the government. The amount withheld is a credit against the income taxes the employee must pay during the year. Nonresident aliens are also subject to withholding tax—on earned income, as well as on other income such as interest and dividends from the securities of U.S. companies that they own.
The vast majority of people who are employed in the United States are subject to tax withholding.
- Withholding tax is a set amount of income tax that an employer withholds from an employee’s paycheck and pays directly to the government in the employee's name.
- The money taken is a credit against the employee’s annual income tax bill.
- If too much money is withheld, an employee will receive a tax refund; if not enough is withheld, an employee will have additional taxes due.
Understanding Withholding Tax
Tax withholding is a way for the U.S. government to maintain its pay-as-you-go (or pay-as-you-earn) income tax system—taxing at the source of income, rather than trying to collect income tax after wages are earned.
There are two different types of withholding taxes employed by the Internal Revenue Service (IRS) to ensure that proper tax is withheld in different situations.
U.S. resident withholding tax
The first and more commonly discussed withholding tax is the one on U.S. residents’ personal income, which every employer in the United States must collect. Under the current system, employers collect the withholding tax and remit it directly to the government, with employees paying the remainder when they file a tax return in April each year.
If too much tax is withheld, it results in a tax refund. However, if not enough tax has been held back, then the individual will owe money to the IRS.
Generally, you want about 90% of your estimated income taxes withheld and sent to the government. This ensures that you never fall behind on income taxes (something that can result in heavy penalties) and that you are not overtaxed throughout the year.
Investors and independent contractors are exempt from withholding taxes but not from income tax—they are required to pay quarterly estimated 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%.
You can easily perform a paycheck checkup using the IRS’s tax withholding estimator. This tool helps identify the correct amount of tax withheld from each paycheck to make sure you don’t owe more in April. To use the estimator, you'll need your most recent pay stubs, your most recent income tax return, your estimated income during the current year, and other information.
Nonresident aliens who earn money in the U.S. are also subject to a withholding tax on that income.
Nonresident withholding tax
The other form of withholding tax is levied against nonresident aliens to ensure that proper taxes are paid on income sources from within the United States. A nonresident alien is someone who is foreign-born and has not passed the green card test or a substantial presence test.
All nonresident aliens must file Form 1040NR if they are engaged in a trade or business in the United States during the year. If you are a nonresident alien, there are standard IRS deduction and exemption tables to help you figure out when you should be paying U.S. taxes and which deductions you may be able to claim.If there is a tax treaty between your country and the United States, that can also affect withholding tax.
History of Withholding Taxes
Tax withholding first occurred in the United States in 1862 at the order of President Abraham Lincoln to help finance the Civil War. The federal government also implemented excise taxes for the same purpose. Tax withholding and income tax were abolished after the Civil War in 1872.
The current system was accompanied by a large tax hike when it was implemented in 1943. At the time, it was thought that it would be difficult to collect taxes without getting them from the source. Most employees are subject to withholding taxes when they are hired and fill out a W-4 Form. The form estimates the amount of taxes that will be due.
The withholding tax is one of two types of payroll taxes. The other type is paid to the government by the employer and is based on an individual employee’s wages. It contributes to funding for Social Security and federal unemployment programs (since the Social Security Act of 1935) as well as Medicare (since 1966).
The majority of U.S. states also have state income taxes and employ tax withholding systems to collect taxes from their residents. States use a combination of the IRS W-4 Form and their own worksheets.
Nine states—Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming, and New Hampshire—do not charge income taxes. However, New Hampshire does tax dividends and income from investments, although it voted to gradually phase out this practice by 2027.
What Is the Purpose of Withholding Tax?
The purpose of withholding tax is to ensure that employees comfortably pay whatever income tax they owe. It maintains the pay-as-you-go tax collection system in the United States. It fights tax evasion as well as the need to send taxpayers big, unaffordable tax bills at the end of the tax year.
How Much Tax Should You Have Withheld?
The amount of income tax you contribute from each paycheck depends on several factors, including total annual earnings and your filing status.
Why Did My Employer Withhold Too Much/Too Little Tax?
Federal tax withholding is based on the information you provide on your W-4 form, which you fill out and give to your employer when you start a job. If you are significantly overpaying or underpaying on income tax, you’ll probably need to fill out this form again with more up-to-date information.
Who Qualifies for Exemption From Withholding?
Employees with no tax liability for the previous year and who expect no tax liability for the current year can use Form W-4 to instruct their employer not to deduct any federal income tax from their wage. This exemption is valid for a calendar year.