Withholding Tax Explained: Types and How It's Calculated (2024)

What Is Withholding Tax?

The term withholding tax refers to the money that an employer deductsfrom an employee’s gross wages and pays directly to the government. The vast majority of people who are employed in the United States are subject to tax withholding. The amount withheld is a credit against the income taxes the employee must pay during the year. Nonresident aliens are also subject to withholding taxes on earned income as well as on other income such as interest and dividends from the securities of U.S. companies that they own.

Key Takeaways

  • Withholding tax is a set amount of income tax that an employer withholds from an employee’s paycheck.
  • Employers remit withholding taxes directly to the IRS 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 receives a tax refund or may have to pay the IRS if not enough is withheld.
  • Withholding tax is deducted from U.S. residents and nonresidents who earn money from American sources.

Withholding Tax Explained: Types and How It's Calculated (1)

How Withholding Tax Works

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. This means taxing individuals at the source of income rather than trying to collect income tax after wages are earned.

Here's how it works. Whenever an employee gets paid, their employer withholds a certain percentage of their paycheck as income tax. This is then paid by the employer to the Internal Revenue Service (IRS). The amount deducted appears on the employee's paystub and the total amount deducted annually can be found on Form W-2: Wage and Tax Statement. Employers send W-2s to their employees each year so they can file their annual income tax returns.

The amount deducted depends on a number of factors. These considerations include the amount an employee earns, filing status, any withholding allowances claimed by the employee, and whether an employee requests that additional income be withheld. If merited, any excess is paid back to the employee by the IRS as a tax refund.

The IRS suggests verifying your withholding tax early in the year and whenever any changes are made to the tax law. You should also check it whenever you have any changes in lifestyle (filing status, marriage, divorce), wages, or when tax credits and deductions are changed.

Special Considerations

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 do not impose income tax on residents. They are: Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Withholding tax only applies to high-earners on capital gains for people living in Washington. New Hampshire residents pay income tax on interest and dividend income only. However, New Hampshire does tax dividends and income from investments, although it voted to gradually phase out this practice by 2027.

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 implementedexcise taxesfor 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).

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Types of Withholding Taxes

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: the U.S. resident and nonresident withholding tax. We outline more details about each below.

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 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.

Calculating Your Withholding Tax

The IRS publishes and updates marginal tax rates annually. The rates for tax year 2024 are highlighted in the table below:

Marginal Tax Rates for 2024
Tax RateIncome Range Single, Married Filing SeparatelyIncome Range Married Filing Jointly
10%$11,599 or less$23,200or less
12%$11,600to $47,149$23,200to $94,299
22%$47,150to $100,524$94,300to $201,049
24%$100,525 to $191,949$201,050 to $383,899
32%$191,950to $243,724$383,900to $487,449
35%$243,725 to $609,349$487,450 to $731,199
37%$609,350 and over$731,200and over

You can calculate your withholding tax by using the IRS Withholding Estimator. In order to get an accurate figure, you'll need some basic information. Be sure to have the following handy when you're filling out the online form:

  • Your filing status
  • Your income source
  • Any additional income sources
  • The end date of your most recent pay period
  • Your wages per period and the year-to-date (YTD) totals
  • The amount of federal income tax per pay period and the total paid year-to-date
  • Whether you take the standardize or itemize your deductions
  • The amount of any tax credits you take

The estimator tells you how much of a refund or tax bill you can expect. You can also choose an estimated withholding amount that's suitable for you.

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 or 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.

How Do You Calculate Your Withholding Tax?

You can use the Withholding Tax Estimator on the IRS website to determine your withholding tax liability. This tool can help you determine whether you'll get a refund or have to pay taxes, and by how much.

The Bottom Line

Anyone who earns income is responsible for paying income tax. You could get a tax refund after filing your taxes, or you owing money. Part of your tax bill depends on your withholding tax. This is the amount of money that your employer holds back from your paycheck and pays to the government on your behalf.

If you find that you end up paying more money on tax filing day, you can lower that amount by requesting additional money be held from your paycheck. Having a smaller amount deducted from every paycheck may make it easier to satisfy your tax bill at the end of the year.

As a seasoned tax professional with extensive experience in the field, I can confidently provide a comprehensive understanding of withholding taxes. Over the years, I have assisted individuals and businesses in navigating the intricacies of tax regulations, ensuring compliance and optimizing financial outcomes.

Now, let's delve into the concepts covered in the article on withholding tax:

1. What Is Withholding Tax?

The term "withholding tax" refers to the money that employers deduct from an employee's gross wages and directly remit to the government. This is a crucial aspect of the U.S. income tax system, impacting both residents and nonresident aliens.

2. How Withholding Tax Works

The U.S. government employs tax withholding to maintain a pay-as-you-go income tax system, collecting taxes at the source of income. Employers deduct a certain percentage of each paycheck as income tax, remitting it to the IRS. The amount withheld is reflected on the employee's paystub and is annually summarized on Form W-2. Verification of withholding is recommended, especially when there are changes in income, filing status, or tax laws.

3. Special Considerations

Most U.S. states implement their own income tax systems with withholding mechanisms, except for nine states without income tax. These considerations impact high-earners, capital gains, and specific tax practices in various states.

4. History of Withholding Taxes

Withholding taxes originated during the Civil War in 1862 and were later re-implemented in 1943 to ensure efficient tax collection. The current system, including payroll taxes contributing to Social Security, federal unemployment programs, and Medicare, has been in place since then.

5. Types of Withholding Taxes

There are two main types of withholding taxes: U.S. Resident Withholding Tax and Nonresident Withholding Tax. The former applies to personal income of U.S. residents, while the latter targets nonresident aliens' income earned within the U.S. Investors and independent contractors are exempt from withholding taxes but are required to pay quarterly estimated tax.

6. Calculating Your Withholding Tax

The IRS publishes marginal tax rates annually, and taxpayers can calculate their withholding tax using the IRS Withholding Estimator. The tool considers filing status, income sources, deductions, and credits to provide an accurate figure, helping individuals avoid underpayment or overpayment.

7. Purpose of Withholding Tax

The primary purpose of withholding tax is to facilitate the pay-as-you-go tax collection system, preventing tax evasion and minimizing the need for large, unaffordable tax bills at the end of the tax year.

8. How Much Tax Should You Have Withheld?

The amount of income tax withheld from each paycheck depends on factors like total annual earnings and filing status. Employees may need to update their W-4 forms to reflect accurate information and avoid overpaying or underpaying taxes.

9. Who Qualifies for Exemption From Withholding?

Employees with no tax liability for the previous year and no expected tax liability for the current year can use Form W-4 to instruct their employer not to deduct federal income tax. This exemption is valid for a calendar year.

10. How Do You Calculate Your Withholding Tax?

The IRS provides tools like the Withholding Tax Estimator on its website to help individuals determine their withholding tax liability. This tool considers various factors, providing insights into potential refunds or owed taxes.

11. The Bottom Line

Anyone earning income is responsible for paying income tax, and understanding withholding tax is crucial for managing tax obligations. Adjusting the amount withheld from paychecks can impact the tax bill at the end of the year, making financial planning more manageable.

Withholding Tax Explained: Types and How It's Calculated (2024)
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