Tax withheld is the money an employer deducts from an employee’s gross wages and pays directly to the government. It is one of the ways the US government employs to combat tax evasion.
This guide clearly explains what it means to withhold taxes, the purpose of withholding taxes, and the systematic processes behind it.
What Does It Mean To Withhold Tax?
Investopedia defines Withholding tax as the money an employer deducts from an employee’s gross wages and pays directly to the government.
The amount withheld is a credit against the income taxes the employee is mandated to pay during the year. Nonresident aliens are also open to withholding tax—on earned income, as well as on other income such as interest and dividends from the securities of U.S. companies that they own.
Types of Withholding Taxes
Tax withholding is a way for the U.S. government to preserve its pay-as-you-go (or pay-as-you-earn) income tax system, rather than trying to collect income tax after wages are earned.
Governments use tax withholding as a means to combat tax evasion and sometimes impose additional tax withholding requirements if the recipient has been delinquent in filing tax returns, or in industries where tax evasion is perceived to be common.
There are two basic tax withholding methods adopted by the IRS:
1. US Resident Withholding Tax
The first type of withholding tax is the one on U.S. residents’ personal income, which every employer in the United States must collect. Currently, employers collect the withholding tax and remit it directly to the government, with employees paying the remainder when they file a tax return in April each year.
In a case where too much tax is withheld, it can result in a tax refund. However, if not enough tax has been held back, then the individual will have to remit money to the IRS.
For most US residents, they prefer that 90% of their estimated income taxes are sent to the government to avoid falling short on income taxes.
Investors and independent contractors are excused from withholding taxes but not from income tax—they are 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 set at 24%.
To operate as a business in the United States, you need to have a license. See How To Apply For And Get A Business License
2. Non-resident withholding Tax
A nonresident alien is someone who was born outside of the United States and has not yet received a green card or passed a meaningful presence test.
Nonresident aliens are subject to the other type of withholding tax, which is imposed to guarantee that due taxes are paid on income earned within the United States.
If a nonresident foreign engages in a trade or business in the United States during the year, they must file Form 1040NR. So, if you are a nonresident alien, you can use the normal IRS deduction and exemption tables to figure out when you should pay US taxes and which deductions you may be eligible for.
If your country and the United States have a tax treaty, it may have an impact on withholding tax.
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What Is the Purpose of Withholding Tax?
The purpose of withholding tax is to ensure that employees easily pay whatever income tax they owe. It maintains the pay-as-you-go tax collection system in the United States which combats tax evasion as well as the need to send taxpayers big, unaffordable tax bills at the end of the tax year.
Tax Withholding is required to be done by the employer of someone else, taking the taxpayer funds out of the employee or contractor’s salary or wages. The withheld taxes are then paid by the employer to the IRS, and applied to the account of the employee, if applicable. The employee may also be required by the government to file a tax return self-assessing one’s tax and reporting withheld payments.
How Much Tax Should You Have Withheld?
The percentage of tax withheld in the US differs across income levels. According to Internal Revenue Service (IRS), you must withhold tax at the statutory rates available unless a reduced rate or exemption under a tax treaty applies. For U.S. source gross income that is not effectively connected with a U.S. trade or business, the rate is usually 30%. Generally, you must withhold the tax at the time you pay the income to the foreign person.
Additionally, you can also use the tax withholding estimator to estimate the federal income tax you want your employer to withhold.
A tax withholding estimator can be used for the following:
- Estimate your federal income tax withholding
- See how your refund, take-home pay, or tax due are affected by the withholding amount
- Choose an estimated withholding amount that works for you
The results will be generated based on your inputs.
Don’t use this tool if:
- You have a pension but not a job. Estimate your tax withholding with the new Form W-4P.
- You have nonresident alien status. Use Notice 1392, Supplemental Form W-4 Instructions for Nonresident Aliens.
- Your tax situation is complex. This includes alternative minimum tax, long-term capital gains, or qualified dividends. See Publication 505, Tax Withholding and Estimated Tax.
Who Qualifies for Exemption From Withholding?
To file for an exemption from tax withholding, you need to use a Form W-4 to determine how much federal tax withholding and additional withholding you need from your paycheck. Form W-4 tells an employer the amount to withhold from an employee’s paycheck for federal tax purposes.
Additionally, employees with no tax liability for the previous year and who expect no tax liability for the current year can use Form W-4 to instruct their employer not to deduct any federal income tax from their wage.
A Form W-4 claiming exemption from withholding is useful for only the calendar year in which it’s furnished to the employer. To continue to be exempt from withholding in the next year, an employee must give you a new Form W-4 claiming exempt status by February 15 of that year.
This date is delayed until the next business day if it falls on a Saturday, Sunday, or legal holiday. If the employee doesn’t give you a new Form W-4, withhold tax as if he or she is single or married filing separately with no other entries in step 2, 3, and 4.
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How to Claim Exempt Status on a W-4
Here’s how to file for tax withheld exemption on W-4.
As stated in hrblock,com, to claim an exemption, you must complete only lines 1, 2, 3, 4, and 7 and sign the form to validate it.
(In Box 7, write “EXEMPT”. Writing this will guarantee that withholdings are not taken from your future paychecks.)
Your exemption for 2020 expires on February 17, 2021.
To claim exemption from withholding, certify that you meet both of the conditions above by writing “Exempt” on Form W-4 in the space below Step 4(c) and complete Steps 1 and 5. Do not complete any other steps on Form W-4. If you claim an exemption from withholding, you will need to submit a new Form W-4 by February 16, 2021.
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Withholding Tax Formula
Federal tax withheld is usually done based on the information you provide on your W-4 form, which you fill out and give to your employer when you start a job. If you are significantly overpaying or underpaying on income tax, you’ll probably need to fill out this form again with more up-to-date information.
Here are the steps to calculate withholding tax:
1. Gather Relevant Documents
First, gather all the documentation you need to reference to calculate withholding tax. The withholding tax amount depends on a number of factors, so you’ll need the employee’s W-4 to help with your calculations, as well as the withholding tax tables and the IRS worksheet.
2. Review the Employee’s W-4 Forms
Second, make sure you have the correct form. You’ll need to refer to the employee’s Form W-4 to find the following details relevant to the withholding tax calculations, including their filing status, the number of dependents, additional income information, and any additional amounts that the employee requests to be withheld.
3. Review Payroll Details
Here you’ll need to gather information from payroll to calculate employee withholding tax. Here’s the information you’ll need for your calculations:
- Payroll period details, including the frequency of your pay periods (weekly, biweekly, or monthly) and the amount of time for that particular period.
- The gross pay amount for the pay period, i.e. the total amount paid for the pay period, either in salary or taxable wages.
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4. Choose Your Calculation Method
Once yu=ou’ve taken the first three steps, you need to calculate withholding tax, you need to choose a calculation method. There are two methods you can choose from:
- The Wage Bracket Method: In this method, you are to use the IRS income tax withholding tables to find each employee’s wage range. The instructions and tables can be found in IRS Publication 15-T.
- The Percentage Method: The percentage method is more complex and instructions are also included in IRS Publication 15-T. The instructions vary based on whether you use an automated payroll system or a manual payroll system. The worksheet walks you through the calculation, including determining the employees’ wage amount, accounting for tax credits, and calculating the final amount to withhold.
When to Check Your Withholding
It’s advised you check your tax withholding every year, especially when you have a major life change like:
- New job or other paid work
- Major income change
- Childbirth or adoption
- Home purchase
Additionally, you can check your withholding if you changed your tax withholding mid-year
FAQs On Tax Withholding
The amount of income tax you contribute from each paycheck depends on several factors, including total annual earnings and your filing status.
The federal withholding tax rate an employee owes depends on their income level and filing status. This all depends on whether you’re filing as single, married jointly or married separately, or head of household.
Use the IRS Withholding Estimator to estimate your income tax and compare it with your current withholding. You’ll need your most recent pay stubs and income tax return.
Employers are required by law to withhold employment taxes from their employees. Employment taxes include federal income tax withholding and Social Security and Medicare Taxes.
Some governments have written laws that require taxes to be paid before the money can be spent for any other purpose. This ensures the taxes will be paid first and will be paid on time, rather than risk the possibility that the tax-payer might default at the time when a tax falls due in arrears.
- hrblock.com – Am I Exempt from Federal Withholding?
- irs.gov – Topic No. 753 Form W-4 – Employee’s Withholding Certificate
- investopedia.com – Withholding Tax
- debitoor.com – Withholding tax – What is withholding tax?
- freshbooks.com – How to Calculate Withholding Tax: A Simple Payroll Guide for Small Business