Understanding the U.S. Tax Withholding System

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Understanding the U.S. Tax Withholding System

People’s paychecks were not always deducted of income taxes. Income tax withholding is, in reality, a very new concept. Prior to 1943, taxes were only withheld in spurts when the government required additional funds. This article describes how we got at the present system of withholding income taxes from your paycheck and how it works.

Key Takeaways

  • When an employer pays an employee, withholding tax is deducted from the earnings.
  • The origins of the withholding tax may be traced back to 1862, when it was utilized to pay the Civil War.
  • Employees fill out IRS Form W-4 to calculate how much tax should be withheld from each paycheck.
  • Individuals may make better personal financial choices by staying updated about withholding amounts and resubmitting W-4s as required.

The Development of the Tax Withholding System

Tax withholding was originally implemented in 1862 by President Abraham Lincoln to assist fund the Civil War. For the same goal, the federal government imposed a slew of excise taxes.

However, in 1872, not only was tax withholding removed, but the income tax was completely repealed.

Income tax became permanent once the 16th Amendment was ratified in 1913. However, following significant criticism, withholding restrictions were removed in 1917. This is because collecting income taxes from workers placed a significant burden on companies by putting them in the position of tax collector as well as company owner.

It would only be 18 years until tax withholding was reinstated this time. Employers began withholding Social Security taxes after the Social Security Act was approved in 1935. With the passage of the Current Tax Payment Act by Congress in 1943, this shift prepared the path for income taxes to be withheld once again. War expenditures were once again cited to justify tax withholding.

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“War is the health of the state,” said the writer and philosopher Randolph Bourne in the early twentieth century. Not only were taxes to be withheld again, but a significant tax increase was also implemented. Income tax was raised from a levy paid solely by a few high-earning Americans to one paid by both the affluent and the average man. The government was unsure that it would be able to collect the increased taxes from its people if they were not withheld at the source.

The prominent economist Milton Friedman, who worked for the Treasury’s Tax Research Division at the time, contributed create the 1943 tax withholding system. While he never apologized for his involvement, Friedman subsequently said that he wished withholding had not been required. Nonetheless, the system has been in place ever since, and few people can recall a period before tax withholding.

How Does Tax Withholding Work?

People paid their complete income tax bills for the preceding year once a year on March 15, or in quarterly payments, in the early days of the income tax, when there was no withholding.

Taxes are collected at the source under today’s tax withholding system. This implies that wage employees never see the tax money they owe. Their employers deduct it from their paychecks and send it straight to the federal government.

The amount of income tax withheld from each paycheck is determined by how the employee completes IRS Form W-4. This form is not filed to the government; rather, it is used by the employee and the employer to calculate how much tax to withhold.

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Form W-4 provides a worksheet to assist taxpayers in calculating their withholdings depending on the number of jobs they hold, their marital status, and the number of dependents. It makes no difference how this form is completed as long as at least 90% of the tax eventually payable in April is withheld from the employee’s paychecks throughout the year. Taxpayers face penalties and fines if less than 90% is withheld.

Under the present withholding system, consumers either pay the balance of what they owe or get a refund if too much tax was withheld. Every paycheck also has Social Security and Medicare taxes deducted.

In today’s system, only employee earnings are subject to withholding for the most part. However, there are plenty alternative methods to generate money. Independent contractors, for example, are not subject to withholding, nor is income generated by investors.

The 90% rule remains in effect, but individuals are responsible for calculating and remitting their own quarterly tax payments.

To ensure that you have a proper amount of tax withheld, utilize the IRS’s withholding calculator and, if necessary, file a new W-4 to your employer to modify your withholding amount.

Special Considerations

If a person becomes subject to backup withholding, this rule is suspended. If a taxpayer has not paid taxes in the past, or if the name and Social Security number provided do not match, independent contractor and investment income (as well as certain other unusual types of income) are subject to backup withholding at a rate of 24%. This is an unusual occurrence, however, since most Americans are immune from backup withholding.

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The federal withholding system serves as the basis for 42 states’ withholding of state income taxes. Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming are the only states without a state income tax. Some states, such as Colorado, utilize IRS Form W-4, while others, such as California, have their own withholding worksheets.

Form W-4 does not allow taxpayers to know how much income will be withheld from each paycheck. Using an online calculator, such as the one offered by the IRS, is a useful method to obtain a clear idea of how claiming various amounts of exemptions on Form W-4 would influence your income tax withholding.

The Bottom Line

Most of us take the tax withholding system for granted, but it is not. It has come and gone throughout the years in response to the government’s need to fund costly projects and wars, as well as taxpayer responses to the system. Understanding how the system works might help you make more educated financial choices.

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