What Is Withholding Tax?

What Is Withholding Tax?

Let me explain withholding tax directly to you: it's the income tax that your employer deducts from your paycheck and sends straight to the government. This amount counts as a credit against the income taxes you owe for the year.

If you're employed in the United States, you're likely subject to this withholding, and it also applies to nonresident aliens on their earned income, plus things like interest and dividends from U.S. securities they own.

Key Takeaways on Withholding Tax

Withholding tax is a fixed amount of income tax your employer pulls from your paycheck and sends to the IRS in your name. It acts as a credit toward your annual tax bill, so if they withhold too much, you get a refund; if too little, you pay the difference when filing your return. This deduction covers payments to both U.S. residents and nonresidents earning from American sources.

How Withholding Tax Works

You should know that withholding tax supports the U.S. government's pay-as-you-go income tax system, taxing you at the source instead of collecting everything after you've earned your wages.

Every time you get paid, your employer withholds a percentage of your paycheck for income tax and pays it to the IRS. You'll see this deduction on your paystub, and the yearly total appears on your Form W-2, which your employer sends you to help file your annual return.

The withheld amount depends on factors like your earnings, filing status, any allowances you claim, and if you request extra withholding. If there's an overpayment, the IRS refunds it to you.

A Tip for Managing Your Withholding

I recommend verifying your withholding tax early in the year or after any tax law changes. Also check it with lifestyle shifts like marriage, divorce, or wage changes, or when tax credits and deductions are updated.

Special Considerations

Most U.S. states have their own income taxes and withholding systems, using IRS Form W-4 combined with state worksheets to determine your withholding. However, eight states—Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming—don't impose income tax on residents.

History of Withholding Taxes

Withholding taxes started in the U.S. in 1862 under President Abraham Lincoln to fund the Civil War, alongside excise taxes, but income taxes were abolished in 1872. The modern system came in 1943 with a major tax increase, seen as necessary to collect taxes at the source. When you start a job, you fill out a W-4 to estimate your taxes due. Withholding is one of two payroll taxes; the other, paid by employers, funds Social Security, unemployment, and Medicare.

Types of Withholding Taxes

The IRS uses two main types of withholding tax: one for U.S. residents and one for nonresidents, ensuring proper taxes in different scenarios.

U.S. Resident Withholding Tax

This is the standard withholding on personal income that every U.S. employer must collect and send to the government. You pay any remainder when filing your April tax return. Over-withholding leads to a refund, under-withholding means you owe money. Aim for about 90% of your estimated taxes withheld to avoid penalties and overtaxation. Investors and independent contractors skip withholding but pay quarterly estimated taxes; if they fall behind, they face 24% backup withholding. Use the IRS Tax Withholding Estimator for a paycheck checkup to ensure the right amount is withheld.

Nonresident Withholding Tax

This tax targets nonresident aliens to collect on U.S.-sourced income. If you're a nonresident alien engaged in U.S. business, file Form 1040NR. IRS tables help with deductions and exemptions, and tax treaties with your country might affect withholding.

Calculating Your Withholding Tax

You can calculate your withholding using the IRS Tax Withholding Estimator. Gather your filing status, income sources, recent pay period details, wages and YTD totals, federal tax paid per period and YTD, deduction type (standard or itemized), and any tax credits.

The Purpose of Withholding Tax

Withholding tax ensures you pay your income taxes as you earn, maintaining the pay-as-you-go system, fighting evasion, and avoiding large end-of-year bills.

Why Did My Employer Withhold Too Much or Too Little Tax?

Your withholding is based on your W-4 form from when you started the job. If it's off, update the form; if not adjusted, file IRS Form 843 for a refund on over-withholding.

Who Qualifies for Exemption From Withholding?

If you had no tax liability last year and expect none this year, use Form W-4 to tell your employer not to withhold federal income tax, valid for the calendar year.

The Bottom Line

Withholding tax is what your employer deducts from your paycheck and sends to the government toward your income taxes. Everyone earning income must pay taxes, and depending on withholding, you might get a refund or owe more. Adjust withholdings to manage your tax bill—more withheld means a smaller bill later, less means easier payments throughout the year but possibly owing at filing.