What Is Income Tax Withholding and How Does It Work?
“What happened?!” may be your response when you look at your paycheck and see all of those deductions, whittling your hard-earned cash down to a (much) lower figure than you expected.
And perhaps, if you look more closely, you’ll notice a line on your paystub that shows a major amount of money subtracted and think, What is withholding tax? And why do they take so much?
Federal and state withholding taxes, also known as “taxes withheld,” are funds that your employer takes out and sends to the government to help federal programs. These taxes have a purpose, and in the long run, you’ll probably be glad they are deducted from your check rather than owed as a mega lump sum on Tax Day.
Read on to learn more about tax withholding, including factors that impact how much gets deducted and how to calculate your withholding taxes.
Key Points
• Income tax withholding deducts money from your paychecks to cover your estimated tax liability, preventing large year-end bills.
• Factors that affect tax withholding include income, filing status, claimed allowances, and extra withholding requests.
• You can adjust your W-4 form to balance withholding, avoiding overpayment or tax debt.
• Withholding exemptions are available for those with no tax liability.
• Withheld taxes support federal programs and public services.
What is Income Tax Withholding?
Many people think their taxes are due mid-April, but the Internal Revenue Service (IRS) actually requires you to pay as you go, meaning you need to pay most of your tax during the year, as you receive income, rather than at the end of the year. When you see those federal and possibly state and local taxes being whisked out of each paycheck, that’s exactly what is happening.
A withholding tax is an amount, based on your salary, that your employer sets aside and then pays directly to the government on your behalf. It’s a credit against the full amount of personal income tax you will owe for the year. By doing this, your employer is helping you avoid a surprise tax bill come April. Tax withholding also helps ensure you won’t owe interest or a penalty for paying too little tax during the course of the year.
That said, how much is deducted from your paycheck can vary depending on a variety of factors. You are able to designate what portion of your check goes toward your taxes on the IRS W-4 form (more on that in a bit).
• If you allocate too much, that means more than necessary is taken out, and you will likely receive a tax refund when you file your taxes.
• If you set aside too little, you will probably owe a balance or have what’s known as a “tax bill” due during tax season to make up the difference.
Your federal withholding tax rate depends on your income and tax bracket.
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Factors That Determine Tax Withholding
There are several factors that determine just how much tax is withheld from your paycheck, whether it arrives as a paper check or via direct deposit. These include:
• How much you earn: Generally, the more you earn, the higher the rate at which taxes are withheld
• Your filing status: For instance, you might file your taxes as single, married filing jointly, or married filing separately.
• How many (if any) withholding allowances you claim: Typically, if you claim a higher number of allowances, your withholding will be lower. This means more cash will flow your way on each payday, but you might owe taxes when you file. If you have a lower number of allowances, more money is taken out for taxes, and you could wind up getting a refund when your tax return is processed.
• Whether you decide to have additional money withheld: Some individuals may ask their employers to withhold, say, an extra $100 or more per pay period if they find they typically owe taxes at year’s end.
Recommended: How to Reduce Your Taxable Income
What Is State Income Tax Withholding?
If you live in a state that levies income tax, you will also see tax withholding for that type of tax on your paycheck. There are just nine states that don’t tax earned income. In other words, you will not pay state taxes if you live in:
• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming
The concept of tax withholding works in the same way at the state level as it does at the federal: A certain portion is put toward your future state tax bill, and you may either owe or get a refund, depending on how much you paid in.
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What Is the Purpose of Tax Withholding?
As briefly mentioned above, tax withholding saves you from owing a huge bundle of taxes in April. If people were left to their own devices to set aside money for taxes, well, that might not always be a success. Every time you receive your paycheck, there are bills to pay, dinners out and movies to tempt you, and vacations to plan and take. As a result it can be hard to save money from your salary.
In addition to helping you avoid a surprise tax bill, tax withholding is also a way for the government to maintain its pay-as-you-go income tax system. If you pay too little in taxes throughout the year, you can get hit with an underpayment penalty and interest payments (on top of that surprise tax bill).
Recommended: Your Guide to Filing Taxes for the First Time
Tax and Employment Documents to Know
When you are first hired at a company, you typically fill out a W-4 form. This form is designed to help your employer estimate how much tax you’ll owe by the end of the year. To do this, the form asks you about your family, potential deductions you might claim, and any additional income you earn outside your W-2 job. Based on your answers, your employer will determine how much tax to withhold from your paychecks.
Then when tax time rolls around, you will receive IRS Form W-2. This includes information on how much income you earned in a given tax year, as well as how much you paid in federal, state, and other taxes.
You’ll use this W-2 to file your taxes, and it will determine whether you receive a tax refund, owe more taxes, or break even.
Calculating Income Tax Withholding
It can take a bit of tweaking to find that balance between overpaying in federal withholding and having to pay more when you file your taxes.
Some people like getting a tax refund because it’s a lump sum they can put toward debt or invest. But realize that overpaying is a bit like giving the government a free loan throughout the year.
While there may be fast ways to get a tax refund, perhaps you’d rather just hold onto that money in the first place. If you better balance what is taken out of your paychecks, you could take the excess you would have paid and put it in a high-yield savings account or invest it for the future.
If you’re wondering what is a withholding tax allowance that’s right for you, there’s help. The IRS has a Tax Withholding Estimator you can use based on your current situation. In general, the more allowances or exemptions you have, the less will be withheld from your pay; the fewer the exemptions, the more will be withheld.
While you aren’t asked to fill out a new W-4 each year, you may request one if you think you need to adjust the withholding amount.
Some of the times it might be wise to adjust how much income tax is withheld include:
• Starting a new job or position
• Having a child
• Getting married or divorced
• Buying a house.
Can I Be Exempt from Tax Withholding?
To be exempt from tax withholding means that no federal taxes will be withheld from your pay. You might also have no state or local taxes (if applicable) deducted. Here are the ways in which someone might qualify to be exempt from such taxes:
• If all of your federal income tax was refunded because you have no tax liability and you expect the same thing to happen this year, then you may be exempt from withholding taxes. (But note, Social Security and some other taxes may still be withheld as part of other types of payroll deductions.)
• Certain types of income are considered exempt. For instance, money paid to foster parents for their taking care of children in their homes may be tax-free. Payments from workers’ compensation is another example of funds that may be tax-exempt.
The Takeaway
Paying taxes may not be fun, but it’s important to remember that this money is put toward things we all enjoy, like smooth roads and education programs. And federal withholding from your paycheck keeps you from having a giant bill when you file taxes.
When it comes to tax withholding, it’s important to understand how much is being withheld from each paycheck and whether you need to modify your W-4 to find a better balance between overpaying and owing more money come Tax Day.
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FAQ
Does the government pay for income tax withholdings?
Money that is withheld from your earnings, known as income tax withholding, goes to the government. These dollars help pay for federal programs that benefit citizens and keep our country running, from education to transportation to security.
How can someone qualify for a withholding exemption?
To qualify as tax-exempt, you would have to have had no tax liability in the previous year and expect the same status in the current tax year. Also keep in mind that some forms of income may be tax-exempt, such as payments for in-home foster care of children or for workers’ compensation.
Why has my employer withheld too much income tax?
If your employer withheld too much income tax, then you will likely get a refund at tax time. You can update your withholding on your W-4 form; the more allowances you have, the less money will be withheld to cover your tax liability.
Why has my employer withheld too little income tax?
If you wound up owing the IRS money at tax time, the issue could be that you have too many exemptions or allowances claimed on your W-4 form, meaning your employer is not withholding enough money from your paycheck. You may want to adjust your W-4, knowing that the lower your number of allowances, the more money your employer with withhold and send to the IRS on your behalf.
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