November 14, 2019

Understanding the U.S. Tax Withholding System

Income taxes weren’t always withheld from people’s paychecks. In fact, income tax withholding is a relatively recent development. Before 1943, taxes were only withheld in spurts when the government needed to raise extra revenue. This article explains how we arrived at the current system that takes income taxes out of your paycheck and how this withholding process works.

How Does Tax Withholding Work?

In the early days of the income tax, when there was no withholding, people paid their full income tax bills for the previous year once a year on March 15, or in quarterly installments. Under today’s tax withholding system, taxes are collected at the source. This means that wage earners never see the money that they owe in taxes—it’s taken by their employers out of their paychecks and transmitted directly to the federal government.

The amount of income tax that is withheld from each paycheck depends on how an employee fills out IRS Form W-4. This form is not submitted to the government—it is only used by the employee and the employer to determine how much tax to withhold. Form W-4 includes a worksheet to help taxpayers determine their withholdings, based on the number of jobs they hold, marital status, and dependents.

It doesn’t really matter how this form is filled out, as long as it results in at least 90% of the tax ultimately due in April being withheld from the employee’s paychecks throughout the year. If less than 90% is withheld, taxpayers are subject to penalties and fines. Under the current withholding system, each April, people either pay the remainder of what they owe, or, if too much tax has been withheld, get a refund. Social Security and Medicare taxes are also withheld from every paycheck.

With today’s system, only the wages earned by employees are subject to withholding (for the most part). There are many other ways of earning income, however. For example, independent contractors aren’t subject to withholding, and neither is the income earned by investors. The 90% rule still applies, but individuals are responsible for calculating and remitting their own tax payments on a quarterly basis.

An exception to this rule arises if an individual becomes subject to backup withholding. If a taxpayer hasn’t paid taxes in the past, or the name and Social Security number reported don’t match, independent contractor and investment income (and some other uncommon categories of income) become subject to backup withholding at a rate of 28% (as of 2009). This situation is rare, though, because most Americans are exempt from backup withholding.

The federal withholding system provides the model that 41 states use to withhold state income taxes. Nine states—Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming—don’t have a state income tax. Some states use IRS Form W-4, while others have their own withholding worksheets.

Form W-4 doesn’t give taxpayers a way to actually see how much income will be withheld from each paycheck. A good way to get a clear picture of how claiming different numbers of exemptions on form W-4 will affect your income tax withholding is to use an online calculator.

The Bottom Line

Most of us take the tax withholding system for granted, but it’s not really a given. It has come and gone over the years with the government’s desire to finance expensive projects and wars, and in response to the reactions of taxpayers to the system. Understanding how the system works can help you make informed decisions about both your political views and your personal finances.

To read the original article, please visit Investopedia.