What Is Withholding Tax?
Withholding tax is a set amount of money that employers take or “withhold” from an employee’s paycheck. This money is then remitted to both the local and federal government on behalf of the employee.
The money that’s withheld by the employer acts as a credit against the employee’s annual income taxes. Those who have too much money withheld will receive a tax refund or money back from either the local or federal government (or both, depending on the circumstance). Those who didn’t have enough money withheld will be required to pay additional annual taxes.
How Is The Amount Of Tax Withheld Calculated?
The exact amount is influenced by what an individual puts on their IRS Form W-4 (also known as the Employee's Withholding Allowance Certificate). This form is given to any new employee whenever they start working at a company. An individual provides key information such as marital status, dependents, and physical disabilities. From there, a copy goes directly to the IRS.
If a W-4 is filled out incorrectly, an individual could end up owing more taxes when filing a tax return. To ensure this doesn’t happen, it’s recommended to update a W-4 Form whenever a big life event such as a marriage, divorce, or birth of a child occurs. Luckily, employees can easily change their tax withholding amount by simply submitting an updated W-4 form to their employer.
Example of Withholding Tax
Let's say John’s yearly salary is $72,000. Though he earns $6,000 a month, his employer withholds $1,500 from his paycheck, leaving $4,500 for John. Of that $1,500, parts of it goes to state income tax, federal income tax, unemployment, and Medicare liabilities. Individuals (except 1099 employees) can easily look at their pay stubs to see the exact amount their employer is withholding.
What Income Is Subject To Tax Withholding?
According to the IRS, regular pay (e.g. commissions, vacation pay, reimbursements, other expenses paid under a nonaccountable plan), pensions, bonuses, commissions, and gambling winnings are all incomes that should be included in this calculation.
Dividends and capital gains are not subject to withholding tax. Self-employed people (or 1099 employees) generally don't pay withholding taxes. They typically make quarterly estimated payments.
The Importance Of Tax Withholding
With tax withholding, federal and local governments are able to receive steady cash flow throughout the year, rather than waiting for annual tax returns. It also reduces the risk of taxpayers being unable to pay their taxes. Most importantly, individuals who have taxes withheld aren’t blindsided by huge tax bills on tax day.