Posted by Abundant Wealth Planning LLC

What Is a Withholding Tax?

What Is a Withholding Tax?

A withholding tax is an amount that an employer takes from its employees' wages and pays it directly to the government. The amount withheld is an income tax credit that the employee must pay during the year. It is also an income tax (interest and dividends) on securities held by a non-resident alien and other income paid to non-residents in a country.


Key Points To Note

• A withholding tax takes a certain amount of money from an employee's salary and pays it to the government.

• The money withdrawn is an employee's annual tax credit.

• If a lot of money is withheld, the employee will receive a tax refund; if it is not sufficiently maintained, the employee will have an additional tax account.

Understanding Withholding Tax

Withholding tax is a way for the U.S. government to tax the income source, rather than collect income tax after earning a salary. There are two types of withholding taxes used by the Internal Revenue Service (IRS) to ensure that the corresponding taxes are withheld in different situations.

A Brief History of Withholding Taxes

Withholding tax first appeared in the United States in 1862 by order of President Abraham Lincoln to help finance the Civil War. The federal government has also implemented a large number of excise taxes for the same purpose. After the Civil War of 1872, withholding taxes and income taxes were abolished. 

The current system was put in place in 1943 and was accompanied by a sharp increase in taxes. It was believed that it would be difficult to collect taxes without getting them at the source. Most employees are subject to withholding income tax when employed and complete Form W-4. The form estimates the amount of tax that will be due.

Withholding tax is one of the two types of social charges. The other type is paid by the employer to the government and is based on each employee's salary. It is used to fund federal social security and unemployment programs (initiated by the Social Security Act of 1935) and Medicare (initiated in 1966).


Tax withholding for U.S. residents

The first and most discussed withholding tax is applied to U.S. residents' income, which must be collected by all employers in the United States.

Under the current system, employers collect withholding tax and pay it directly to the government, while employees pay the rest when they file a tax return each year. If it is too much, tax is withheld, resulting in a tax refund. However, if not enough taxes are withheld, the employee owes the IRS.

Typically, you want the government to withhold about 90% of the estimated income tax. It ensures that you will never be left behind with income tax, which comes with stiff penalties, and will not be charged a premium during the year. Investors and independent entrepreneurs are exempt from withholding tax, but not from income tax. If these categories of taxpayers are left behind, they may be subject to withholding tax, which is a higher withholding rate set at 24%.

You can easily perform a paycheck check with the IRS Withholding Tax Estimator. This tool helps you identify the correct amount of withholding for each salary to ensure you don't owe. Using the tool, you will request the latest payment receipts, the latest tax return, estimated income for the current year, and other information. Non-resident aliens who earn money in the United States are also subject to withholding tax on such income.


Withholding Tax for Non-Residents

The other form of withholding tax applies to non-resident aliens to ensure that taxes apply to income sources in the United States. A non-resident alien is born abroad who has not passed the green card exam or a significant presence test. All non-resident aliens must complete Form 1040NR if they are involved in the United States business during the year. If you are a non-resident alien, there are standard IRS exemption and deduction tables to determine when you must pay U.S. taxes and what deductions you can claim.

Special Considerations

U.S. states can also have income taxes, and 41 states and Washington, D.C. use withholding systems to collect from their residents. States use a combination of Form IRS W-4 and their spreadsheets. However, seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) do not collect income tax. New Hampshire and Tennessee do not include tax wages, but dividends and investment income, although both states have voted to end the practice: Tennessee in 2021 and New Hampshire in 2025.



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