What is Withholding Tax?
A withholding tax is a tax that your employer withholds from your paycheck to pay taxes to the government on your behalf.
Your paychecks don’t include your full salary. Instead, your employer takes out withholding taxes. Your employer passes this money along to the government to pay several different taxes, including federal income tax, Social Security tax, and Medicare tax. In the case of certain taxes, such as Social Security and Medicare taxes, your employer automatically withholds a certain amount. With income tax, you have some say over how much money your employer withholds from your paychecks. You can change the amount that your employer withholds from your paycheck by changing the number of allowances you claim on your W-4 form. The more allowances you claim, the less withholding tax comes out of your paycheck.
Let’s say Brad recently started a new job. Just like the rest of us, Brad has to pay tax on his income. Rather than Brad paying his income taxes in one lump sum at the end of the year, his employer uses withholding taxes to take money out of his paycheck and send it to the IRS throughout the year. Then, at the end of the year, Brad’s tax bill is likely already paid. If Brad’s employer withheld too much in taxes, Brad would get a tax refund at the end of the year. If they have not withheld enough, Brad would have a tax bill to pay.
Withholding taxes are like paying your rent every month…
Your landlord wants to be paid every month that you live in their building, not just in a lump sum at the end of the year. Likewise, the IRS wants to be paid taxes on your income as you’re earning it, not after the fact.
Withholding taxes allow the U.S. Government to collect income and FICA (Social Security and Medicare) taxes throughout the year, rather than just charging people a lump sum when they file their annual taxes. By requiring employers to collect and forward the withholding taxes, the government is guaranteed to get their money.
For U.S. citizens and residents, the process is relatively straightforward. When an employer hires someone, the employee is required to fill out a W-4 form. This form gives the employer the information they need to estimate how much withholding tax to take out of the employee’s paycheck.
For non-residents, meaning those without a green card or who do not spend enough time in the United States, they must file Form 1040NR to report their earnings to the government and pay taxes on those earnings. Even though they don’t primarily live in the United States, they still must pay taxes on the money they earn from business here.
In general, an employer will withhold about 90% of your income tax burden throughout the year. That way, you don’t fall behind on your taxes, but you also don’t overpay. If the end of the year rolls around and you haven’t paid enough income taxes, you’ll owe the IRS money. If the end of the year comes around and you’ve overpaid, the government gives you a refund for the amount you’ve overpaid.
If you’re a freelance or contract worker, you probably don’t have taxes withheld from the checks you receive. Instead, you have to pay your taxes yourself. Freelance workers generally have to pay their taxes quarterly. The IRS has a pay as you earn philosophy, meaning you can’t just wait until the end of the year to pay your entire tax bill. Freelance workers who don’t pay their tax bill on time might face penalties and might be subject to backup withholding, which is when those paying them must withhold taxes at a rate of 24%.
Freelance workers don’t just have to pay their income tax bill — they also have to pay the other withholding taxes such as Social Security and Medicare taxes (aka FICA taxes). Most employees pay 6.2% in Social Security taxes and 1.45% in Medicare taxes, while their employers pay an equal amount. Freelance workers have to pay both parts of the tax, meaning they pay 12.4% in Social Security taxes and 2.9% in Medicare taxes.
In addition to the income taxes that the federal government requires, most states also collect an income tax. Forty-one states use withholding tax to collect the tax bill from taxpayers. Additionally, your city or county may also collect income taxes, which may also come out of your paycheck as a withholding tax.
Social Security and Medicare taxes are payroll taxes. There are other types of withholding taxes as well, but you don’t pay them. Your employer has to pay two additional types of payroll taxes: FUTA (which stands for Federal Unemployment Act) and SUTA (which stands for State Unemployment Act).
Employers are required to pay FUTA and SUTA taxes for each of their employees. These taxes go to fund unemployment programs that provide income for individuals who are facing a period of unemployment.
It might seem like a daunting task for an employer to have to figure out how much tax to withhold from their employees’ paychecks. The good news is, they have some guidance on this from the IRS and from the W-4 forms their employees fill out.
First, a new employee fills out a W-4 form, which is how they indicate to their employers how much they want their employers to withhold in taxes. On the W-4 form, the employee can claim allowances, such as allowances for having children. The more allowances you claim, the more of your paycheck you get each month. It might seem like you get more money for claiming more allowances, but be careful: If your allowances outweigh the deductions you have at the end of the year, you’ll end up owing the IRS a hefty tax bill. You may wish to consult a tax professional.
After the employee has filled out their W-4 form, the employer uses guidance from the IRS to determine how much they should withhold for taxes. The IRS provides instructions for withholding taxes and provides tables to show employers how much they should withhold based on the employee’s salary, marital status, and the number of allowances. The IRS publishes this information annually in its Publication 15-T.
Taxpayers can also double-check to make sure they’re paying the appropriate amount in taxes throughout the year. The IRS has a withholding calculator on its website that you can use to make sure you’re on track with your taxes.
Many people might find themselves confused when it comes to filling out their W-4 form and deciding how many allowances to claim. Most childless adults probably find themselves claiming two allowances at most, but possibly as low as zero. Then, if you have children or other dependents, you’ll claim more.
It varies from person to person as to how many allowances are best. It’s a balancing act –- You don’t want to pay too little and end up owing a big tax bill at the end of the year. And while paying too much might mean a big tax refund, it also means the IRS got to hold onto your money all year instead of you having it to spend or invest.
Ultimately, it makes sense to try to get as close as possible to your actual tax bill taken out of your paychecks. Then you don’t end up paying in at the end of the year, but you also aren’t giving the government an interest-free loan.
You may wish to consult with a tax professional.
The short answer is: yes. Virtually everyone earning an income in the United States must pay income and FICA taxes. The onus is on your employer, not on you, to make sure they are withholding taxes.
If you are a freelance or contract worker, it's possible that those who are cutting your paycheck aren’t withholding taxes on your behalf. But that doesn’t mean you’re off the hook. As a freelancer, you should be paying your income and FICA tax bill every quarter.
Backup withholding is a withholding tax that certain individuals have to pay. The backup withholding rate in 2020 is 24%. Businesses and banks might have to withhold taxes for backup withholding on several different types of payments, such as interest payments, dividend payments, and other types of income. As a business, you must withhold money for backup withholding if someone has not given you an appropriate tax identification number. This might occur if you’ve hired a freelancer, and they did not provide you with this information. You also might have to withhold taxes if the IRS instructs you to do so as a result of the individual you're paying not have previously reported income or paid their tax bill.
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