Withholding Tax Explained: Types and How It’s Calculated

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Withholding Tax Explained: Types and How It’s Calculated

What Is Withholding Tax?

The word withholding tax refers to the money deducted from an employee’s gross earnings and paid directly to the government by the employer. Tax withholding applies to the great majority of persons who work in the United States. The amount withheld is a credit against the employee’s taxable income for the year. Nonresident aliens are also liable to withholding taxes on earned income as well as other income such as interest and dividends on assets owned by nonresident aliens in the United States.

Key Takeaways

  • A withholding tax is a specified amount of income tax withheld by an employer from an employee’s paycheck.
  • Employers pay withholding taxes directly to the IRS on behalf of their employees.
  • The money taken is deducted from the employee’s yearly income tax bill.
  • If too much money is withheld, the employee gets a tax return; if not enough is withheld, the employee may have to pay the IRS.
  • Withholding tax is taken from both US citizens and nonresidents who earn money in the US.

Understanding Withholding Tax

Tax withholding allows the United States government to keep its pay-as-you-go (or pay-as-you-earn) income tax system. This entails taxing people at the point of income generation rather than attempting to collect income tax after earnings are collected.

This is how it works. When an employee is paid, their employer deducts a portion of their wages as income tax. This is then paid to the Internal Revenue Service by the employer (IRS).The amount deducted is shown on the employee’s paystub, and the total amount deducted each year is shown on Form W-2: Wage and Tax Statement. Every year, employers provide W-2s to their workers so that they may submit their yearly income tax returns.

The amount removed is determined by a variety of criteria. These factors include an employee’s earnings, filing status, any withholding allowances claimed, and if an employee asks that more income be withheld. The IRS will reimburse any excess to the employee if it is justified.

The IRS recommends confirming your withholding tax early in the year and anytime the tax legislation is changed. You should also review it anytime your lifestyle (filing status, marriage, divorce), salary, or tax credits and deductions change.

Special Considerations

The majority of states in the United States have their own income taxes and use tax withholding systems to collect taxes from their inhabitants. States combine the IRS W-4 Form with their own worksheets.

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Residents in nine states do not pay income taxes. Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, and Wyoming are among them. Only high-earners on capital gains in Washington are subject to withholding tax. Only interest and dividend income is subject to income tax in New Hampshire. New Hampshire, on the other hand, taxes dividends and investment income, however it has agreed to progressively phase out this practice by 2027.

History of Withholding Taxes

Tax withholding was initially implemented in the United States in 1862 by President Abraham Lincoln to help fund the Civil War. Excise taxes were also established by the federal government for the same objective. Tax withholding and income tax were repealed after the Civil War in 1872.

When the present system was adopted in 1943, it was followed by a significant tax increase. It was assumed at the time that collecting taxes without acquiring them from the source would be impossible. When they are recruited, most workers are liable to withholding taxes and must complete a W-4 Form. The form calculates the amount of taxes that must be paid.

One of two forms of payroll taxes is the withholding tax. The other kind is paid to the government by the business and is based on the salaries of each individual employee. Since the Social Security Act of 1935, it has contributed to the financing of Social Security and federal unemployment programs, as well as Medicare (since 1966).

Types of Withholding Taxes

The Internal Revenue Service (IRS) uses two kinds of withholding taxes to guarantee that the right tax is withheld in various situations: the U.S. resident withholding tax and the nonresident withholding tax. More information about each is provided below.

U.S. Resident Withholding Tax

The first and most widely mentioned withholding tax is the one on personal income of US citizens, which every employer in the US is required to collect. Employers collect withholding tax and transmit it immediately to the government under the existing system, with workers paying the remaining when they file their tax returns in April each year.

If too much tax is withheld, a tax refund is issued. However, if insufficient tax is withheld, the person will owe money to the IRS.

In most cases, you want around 90% of your predicted income taxes withheld and sent to the government. This guarantees that you never fall behind on your income taxes (which may result in significant fines) and that you are not overtaxed during the year.

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Investors and independent contractors are free from withholding taxes but not income taxes; they must pay quarterly estimated tax. If these taxpayers fall behind on their payments, they may be subject to backup withholding, which is a higher rate of tax withholding set at 24%.

Using the IRS’s tax withholding estimate, you may quickly do a paycheck inspection. This tool assists in determining the right amount of tax withheld from each paycheck so that you do not owe extra in April. You’ll need your most recent pay stubs, your most recent income tax return, your expected income for the current year, and other information to utilize the calculator.

Nonresident Withholding tax

The second kind of withholding tax is imposed on nonresident foreigners in order to guarantee that adequate taxes are paid on income earned inside the United States. A nonresident alien is a foreign-born person who has not passed the green card or significant presence criteria.

If a nonresident foreign engages in a trade or business in the United States throughout the year, they must submit Form 1040NR. If you are a nonresident alien, you may use normal IRS deduction and exemption tables to determine when you should pay US taxes and which deductions you may be entitled to claim. If your nation and the United States have a tax treaty, it may effect withholding tax.

Calculating Your Withholding Tax

Annually, the IRS announces and adjusts marginal tax rates. The following rates are noted in the table for the 2022 tax year:

Marginal Tax Rates for 2022
Tax RateIncome Range Single, Married Filing SeparatelyIncome Range Married Filing Jointly
10%$10,274 or less$20,549or less
12%$10,275to $41,774$20,550to $83,549
22%$41,775to $89,074$83,550to $178,149
24%$89,075to $170,049$178,150to $340,099
32%$170,050to $215,949$340,100to $431,899
35%$215,950 to $539,899$431,900 to $647,849
37%$539,900 and over$647,850and over

The IRS Withholding Estimator will help you calculate your withholding tax. You’ll need some basic information to obtain an accurate calculation. When filling out the online form, have the following items nearby:

  • Your filing status
  • Your income source
  • Any additional income sources
  • Your most recent pay period’s end date
  • Your period wages and year-to-date (YTD) totals
  • The amount of federal income tax paid every pay period, as well as the total amount paid year to date
  • Whether you take the standard deduction or itemize,
  • The amount of any tax credits you take
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The estimator calculates the amount of your refund or tax bill. You may also choose an expected withholding amount that is appropriate for you.

What Is the Purpose of Withholding Tax?

The goal of withholding tax is to guarantee that workers can easily pay their income taxes. It handles the United States’ pay-as-you-go tax collecting system. It combats both tax evasion and the necessity to issue people large, unsustainable tax bills at the conclusion of the fiscal year.

How Much Tax Should You Have Withheld?

The amount of income tax you pay with each paycheck is determined by various variables, including your total yearly earnings and filing status.

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

The information you submit on your W-4 form, which you fill out and send to your employer when you start a job, is used to calculate federal tax withholding. If you are considerably overpaying or underpaying income tax, you will most likely need to resubmit this form with more current information.

Who Qualifies for Exemption From Withholding?

Employees who had no tax due the previous year and anticipate to have no tax responsibility this year may utilize Form W-4 to urge their employer not to deduct any federal income tax from their pay. This exemption is good for one year.

How Do You Calculate Your Withholding Tax?

To calculate your withholding tax due, go to the IRS website and utilize the Withholding Tax Estimator. This calculator will help you figure out if you’ll receive a refund or have to pay taxes, and how much.

The Bottom Line

Anyone who makes money is required to pay income tax. You might be one of the many people who get a tax refund after submitting your taxes. If you don’t, you can wind yourself paying the IRS money come tax season. Your withholding tax contributes to a portion of your tax burden. This is the amount of money deducted from your salary and paid to the government on your behalf by your employer. If you find yourself paying more money on tax filing day, you may reduce that amount by asking that more money be deducted from your salary. Having a lesser amount collected from each paycheck may make paying your tax bill at the end of the year simpler.

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