Withholding Tax Definition

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What Is a Withholding Tax?

A withholding tax is an amount that an employer withholds from employees’ 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.

Key Takeaways

  • A withholding tax takes a set amount of money out of an employee’s paycheck and pays it to the government.
  • The money taken is a credit against the employee’s annual income tax.
  • If too much money is withheld, an employee will receive a tax refund; if not enough is withheld, an employee will have an additional tax bill.

Understanding Withholding Tax

Withholding taxes 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. For 2020, tax returns are due in July. If too much tax is withheld, it results in a tax refund. However, if not enough tax has been held back, then an employee will owe 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, which has some heavy penalties, but also that you are not overtaxed throughout the year. Investors and independent contractors are exempt from withholding taxes but not from income 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%.

You can easily perform a paycheck checkup using the IRS 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 in order to help finance the Civil War. The federal government also implemented a plethora of excise taxes for the same purpose. After the Civil War, in 1872, tax withholding and income tax were abolished.

The current system was implemented in 1943 and accompanied by a large tax hike. 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 tax. The other type is paid to the government by the employer and is based on each 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, though both states have voted to end this practice—Tennessee in 2022, and New Hampshire in 2025.



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