Withholding

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Withholding: Definition, How It Works, and Key Rules

Overview

Withholding is the portion of an employee’s pay that an employer deducts and remits directly to tax authorities on the employee’s behalf. It covers federal income tax and payroll taxes (Social Security and Medicare), and often state and local income taxes where applicable. Withholding is an estimate of the tax the employee will owe for the year; too little withheld can result in a tax bill and penalties, while too much withheld produces a refund.

How Withholding Works

  • Employers calculate withholding based on the employee’s Form W-4 and payroll information, then remit those amounts periodically to the IRS and relevant state or local tax agencies.
  • Employees complete Form W-4 when hired and must update it after major life changes (marriage, additional dependents, new job) to ensure accurate withholding.
  • Employees can request additional flat-dollar amounts to be withheld or, in limited cases, claim exemption from withholding.

What Form W-4 Requires

When completing Form W-4, employees typically provide:
– Whether they have one or multiple jobs and estimated earnings from additional jobs.
– Marital status and whether a spouse is employed (and their earnings), if applicable.
– Number of dependents.
– Filing status (e.g., single, married filing jointly).
Employers use this information to determine federal income tax withholding.

Federal vs. State Withholding

  • Federal withholding covers federal income tax and FICA payroll taxes:
  • Social Security: 6.2% withheld from employee wages (employer pays an additional 6.2%).
  • Medicare: 1.45% withheld from employee wages (employer pays an additional 1.45%).
  • Combined employee withholding for Social Security and Medicare is 7.65%; the combined employer + employee contribution is 15.3%.
  • Self-employed individuals generally pay both the employee and employer portions (self-employment tax).
  • State and local withholding varies by jurisdiction:
  • Nine states have no state income tax.
  • Seventeen states permit local governments to levy income taxes.
  • Remote or multi-state workers may owe taxes to more than one state; employers may be able to withhold for multiple states.

Other Types of Withholding and Payroll Deductions

  • Retirement plan contributions (401(k), traditional vs. Roth) are often withheld from pay:
  • Traditional (pre-tax) contributions reduce taxable income now and defer income tax until withdrawal.
  • Roth (after-tax) contributions are taxed now but typically tax-free at withdrawal.
  • Other voluntary or court-ordered deductions (health insurance premiums, wage garnishments) may also be withheld.

Special Considerations

  • Under-withholding can trigger tax bills, interest, and penalties at filing time; over-withholding generally results in a refund.
  • Self-employed workers and taxpayers with significant non-wage income (dividends, capital gains, interest, royalties) usually make quarterly estimated tax payments instead of relying on employer withholding.
  • The IRS recommends withholding from unemployment benefits to avoid surprises at tax time.
  • The IRS’s Withholding Compliance Program identifies payroll withholding inconsistencies so taxpayers can correct them.

How Much Should You Withhold?

  • The correct amount depends on income, filing status, dependents, other income sources, and credits. Use Form W-4 and the IRS tax withholding estimator to determine a suitable withholding level.
  • Claiming “0” withholding allowances results in more tax being withheld (larger refunds potential); claiming “1” or more reduces withholding. Those with multiple jobs or who can be claimed as dependents often choose more withholding (or claim 0).

Bottom Line

Withholding ensures an individual’s income and payroll taxes are paid throughout the year. Employees must complete and update Form W-4 to reflect their circumstances. Those with complex income situations or who are self-employed should plan for estimated payments. Use the IRS withholding tools or consult a tax professional to avoid underpayment penalties or unexpected tax bills.