Withholding Tax

What Is a Withholding Tax?

A withholding tax is the amount an employer withholds from an employee’s wages and pays directly to the government. The amount withheld is a credit against the income taxes the employee must pay during the year. It also is a tax levied on income (interest and dividends) from securities owned by a nonresident alien, as well as other income paid to nonresidents of a country. Withholding tax is levied on the vast majority of people who earn income from a trade or business in the United States.

Understanding Withholding Tax

Tax withholding is a way for the U.S. government to tax at the source of income, rather than trying to collect income tax after wages are earned. There are two different types of withholding taxes employed by the Internal Revenue Service (IRS) to ensure that proper tax is withheld in different situations.

U.S. Resident Withholding Tax

The first and more commonly discussed withholding tax is the one on U.S. residents’ personal income that must be collected by every employer in the United States. Under the current system, the withholding tax is collected by employers and remitted directly to the government, with employees paying the remainder when they file a tax return in April each year.

If too much tax is withheld, it results in a tax refund. However, if not enough tax has been held back, then the individual owes money to the IRS.

Generally, you want about 90% of your estimated income taxes withheld by the government. It ensures that you never fall behind on income taxes, a failing that can carry heavy penalties, and it also sees to it that you are not overtaxed throughout the year. Investors and independent contractors are exempt from withholding taxes but not from income tax. (They are required to pay quarterly estimated tax.) If these classes of taxpayers fall behind, they can become liable to backup withholding, which is a higher rate of tax withholding, which is set at 24%.

You can easily perform a paycheck checkup using the IRS’s tax withholding estimator. This tool helps identify the correct amount of tax withheld from each paycheck to make sure you don’t owe more in April. Using the estimator will require your most recent pay stubs, your most recent income tax return, your estimated income during the current year, and other information.

Nonresident aliens who earn money in the U.S. are also subject to a withholding tax on that income.

Nonresident Withholding Tax

The other form of withholding tax is levied against nonresident aliens to ensure that proper taxes are made on income sources from within the United States. A nonresident alien is someone who is foreign-born and has not passed the green card test or a substantial presence test.

All nonresident aliens must file Form 1040NR if they are engaged in a trade or business in the United States during the year. If you are a nonresident alien, there are standard IRS deduction and exemption tables to help you figure out when you should be paying U.S. taxes and which deductions you may be able to claim.

History of Withholding Taxes

Tax withholding first occurred in the United States in 1862 at the order of President Abraham Lincoln to help finance the Civil War. The federal government also implemented excise taxes for the same purpose. Tax withholding and income tax were abolished after the Civil War in 1872.

The current system was accompanied by a large tax hike when it was implemented in 1943. At the time, it was thought that it would be difficult to collect taxes without getting them from the source. Most employees are subject to withholding taxes when they are hired and fill out a W-4 Form. The form estimates the amount of taxes that will be due.

The withholding tax is one of two types of payroll taxes. The other type is paid to the government by the employer and is based on an individual employee’s wages. It is used to fund Social Security and federal unemployment programs (started by the Social Security Act of 1935) as well as Medicare (begun in 1966).

Special Considerations

U.S. states may also have state income taxes, and 41 states and Washington, D.C., employ tax withholding systems to collect from their residents. States use a combination of the IRS W-4 Form and their own worksheets. Seven states — Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming — do not charge income tax. New Hampshire and Tennessee don’t tax wages but do tax dividends and income from investments. Both of these states voted to end this practice — Tennessee in 2021 and New Hampshire by 2025.