What is withholding tax, and how does it work?
In the US, employees are subject to withholding tax, and employers are legally responsible for collecting this tax and passing it on to the IRS.
What is withholding tax?
Withholding tax, or WHT, is a method of tax collection also known as tax retention. Most employed professionals in the US are subject to this type of withholding, including both residents and non-residents who earn their money from American companies, businesses, and endeavors.
To summarize: An employer is legally required to tax a set percentage of an employee’s gross wages, retaining this money for payment directly to the government’s Internal Revenue Service (IRS).
When you start a new job, you’ll usually fill out Form W-4 and detail information pertinent to your federal income tax responsibilities. This will allow your employer to withhold the appropriate amount from you. The amount withheld over the tax year will then be a credit against the income, Medicare, and Social Security taxes you’re due to pay in tax season.
If your employer doesn’t withhold enough, you must account for the difference and make an additional payment to the IRS. If your employer withholds too much and you end up having overpaid your taxes, you’ll instead receive a tax refund/rebate.
How does withholding tax work?
Withholding taxes help the US government and the many different state governments to maintain a Pay-As-You-Go income tax system effectively. WHT massively reduces the gap come tax season between what a person has paid the IRS thus far and what they will owe after final calculations have been made.
Almost every US citizen in an employed role will be subject to federal withholding, and many will also be subject to state withholding according to set rates in their area. This won’t, of course, be the case in any of the states with no local income tax:
Alaska
Florida
Nevada
New Hampshire
South Dakota
Tennessee
Texas
Washington
Wyoming
Though the states above don’t charge state income tax in most circumstances, there are a few exceptions and stipulations to note. New Hampshire, for instance, taxes interest and dividends, and Washington taxes capital gains.
Some states will require new hires to complete not just Form W-4 but a distinct withholding certificate for state income tax, too, so it’s important to check whether this is the case where you live.
How much withholding tax will I pay?
The amount of tax withheld from you each month will be visible on your payslip, and you’ll be able to see the full annual amount on Form W-2: Wage and Tax Statement. If you’re an employee about to be subject to WHT and you’re not sure what to expect, there are several factors to bear in mind.
The amount withheld from your pay will be dependent on the following:
The amount you earned that month
The details of your filing status
Any withholding allowances you’re claiming
Whether you’ve requested that any additional income be withheld
Any changes to your circumstances (e.g., marriage or divorce)
Any changes to your tax credits and deductions
For Social Security, employees will be taxed 6.2 percent up to a limit of $160,200 (with employers matching this for a total tax amount of 12.4 percent).
For Medicare, employees will be taxed 1.45 percent with no limit (again matched by employers for a total tax amount of 2.9 percent). Employees earning over $200,000 annually may also be charged an additional unmatched 0.9 percent for Medicare.
Understanding the different types of withholding taxes
Beyond the distinction between federal withholding tax and state withholding tax, there are a few different types of withholding taxes that you should be aware of:
US resident withholding tax – this is the most commonly discussed withholding tax. Every employer in America must collect at least the federal rate of this tax on behalf of their employees if they are US residents.
Non-resident withholding tax – this is the other form of withholding tax charged (often at a higher rate) against non-resident people working and earning in the US. If you fit into this category, you must file Form 1040NR if you’ve done business within the US in the last year.
Estimated taxes for self-employed professionals, independent contractors, investors, etc. – though not strictly WHT, this is the equivalent for self-employed people. Since they don’t have an employer to withhold their taxes appropriately, they must pay estimated taxes every quarter, then make up the difference in either direction during tax season.
How to calculate your withholding tax
If you know how much tax should ideally be withheld from you over a tax year, you’re in the best possible place to accurately fill out Form W-4 and prevent yourself from paying either too much or too little income tax. But how do you figure out how much tax you need to pay?
Thankfully, it should be fairly simple to get a good idea. The IRS website hosts a federal tax withholding estimator that assesses:
Your filing status – are you Single, Married Filing Jointly, Married Filing Separately, a Head of Household or a Qualifying Widow/Widower?
Your income and withholding – what are your sources of income? Do you need to withhold anything extra due to other income sources?
Your income adjustments, deductions and tax credits – are there any details you need to add that will reduce or increase your tax liability?
You’ll then need to account for possible state-level withholding responsibilities to get a truly accurate picture of what you will owe.
In most cases, if you’ve filled out Form W-4 correctly and been honest about your tax liabilities, you’re far more likely to end up well-balanced during tax season than you are to need to make an additional payment.
If you’re looking for tax advice and guidance on how much of your salary will be withheld, or if you’re self-employed and hoping for help with your estimated taxes, a financial advisor can help.
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Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.