What is a Withholding Tax?

Withholding tax refers to an amount an employer withholds from employees salaried income and submits directly to the federal taxing authorities. Levying of withholding tax takes place at the time of the disbursement of the employees income. The deductions are then given to the federal government by the authorized tax collecting entities.

How Does a Withholding Tax Work?

Withholding tax applies to employees income tax such as Pay As You Earn (PAYE). Basically, the government imposes deduction on income earnings such as:

• Salary or wages
• Commissions
• Pensions
• Bonuses
• Gambling winnings

However, individuals in self-employment don't pay withholding tax. They only make an estimate of their payments on a quarterly basis. Every employee with a salary or wage has a credit against the income taxes which he or she must pay during the year. Withholding tax also applies to interest and dividends earned by an individual from securities owned. Also subject to withholding tax is the income a non-resident of a country earns.

The Origin of Withholding Tax

The introduction of a withholding tax happened first in the United States in 1862. The initiative was introduced following the order of President Abraham Lincoln, who was at the time the president of the United States. Withholding tax was purposely introduced so that it could help in financing the Civil War. Also implemented by the federal government to support the same back then were excise taxes.

Withholding Tax Example

Lets assume that your yearly salary is $24,000. Though you make $20,000 per month, you will only take home $1,800. The reason is that your employer deducts $200 from your monthly salary and submits the amount to the federal and state government on your behalf. The payment your employer deducts from your monthly income is credited to your state income tax, federal income tax, Medicare liabilities, and unemployment. Note that what you state in Internal Revenue Service (IRS) Form W-4, also known as employees withholding allowance certificate is what determines your withholding tax amount. You should provide your employer with information such as the number of dependents and marital status in your Form W-4. A copy of this is then given directly to the IRS. Note that if your allowance claims on Form W-4 are many, then your withholding tax will be less.

Types of Withholding Tax

IRS employs two forms of withholding tax to ensure that proper tax is withheld in various situations. The most common form is withholding tax on personal income which every employer in the United States must collect and pass to the government. The other type of withholding tax is the tax levied against non-United States residents. The taxation ensures that whatever the non-residents earns while residing in the United States is subject to tax. Resident withholding taxes is a means through which the U.S. government collects tax right from the source. Initially, the experience of collecting income tax after earning had proved futile. So, the idea behind this system of collecting income tax was to enable the government to maximize tax collection from its citizens. Collecting tax from the source was seen to be the best way to reach out to every taxpayer. So, for every employed individual, he or she has to ensure that he fills the IRS Form W-4. The form estimates each of the employees tax amounts that an employer should deduct and submit to the tax entities.

Non-United States Resident Withholding Taxes

To ensure efficiency and effectiveness in the collection of tax, the United States government also imposes a tax on non-United States residents. The non-residents refer to those individuals residing in the United States but have not passed the substantial presence test or green card test. Such individuals must file Form 1040NR if they happen to be engaged in any business or trade in the U.S. during the year.

Important of Withholding Tax

One reason why withholding tax matters is that it prevents taxpayers from accumulating huge tax bills at the end of a financial year. By allowing employers to deduct and remit the tax on a monthly basis, it eases the tax burden on the employees side. In other words, it is easier to pay tax in bits than in a lump sum. Again, withholding tax ensures that the federal and local governments have steady cash flow through the financial year to finance their projects. There is no fear that the taxpayers will default to pay their taxes as the government is able to collect from them on a monthly basis.

The Bottom Line

Generally, a taxpayers liability may either be less or more than what he or she pays yearly on withholding tax. In such situations, a taxpayer may either receive a tax refund from the government or pay extra money to the government. Most importantly, you ensure that your payroll is accurate. The reason is that when you remit your withholding tax with mistakes, the liability will always be on the taxpayer, regardless of whether the mistake was made by the employer.