You’ve likely noticed the IRS withholds a portion of your paycheck before it ever reaches your bank account. This is due to withholding tax, a system the IRS uses to collect income tax throughout the year. Whether you’re an employee trying to fine-tune your paycheck or a business owner handling payroll, you should know how withholding works. It will help manage cash flow, avoid underpayment penalties and ensure you aren’t caught off guard come tax season.
A financial advisor can help you assess whether the correct amount is being withheld and recommend adjustments to avoid surprises come tax time.
What Is Withholding Tax?
Withholding tax refers to the portion of your income that an employer deducts from your paycheck and sends directly to the government as a prepayment of your federal (and sometimes state and local) income taxes. Rather than paying your entire tax bill in one lump sum at the end of the year, the IRS collects taxes incrementally throughout the year through this withholding system.
This system applies primarily to employers who withhold federal income tax based on the information provided on employees’ W-4 forms. The IRS credits the amount withheld toward your annual tax liability. If they take too much, you’ll receive a refund. If they don’t withhold enough, you may owe money when you file your tax return.
Types of Withholding and Payroll Taxes
The IRS deducts several types of withholding and payroll taxes from a paycheck:
- Federal Income Tax Withholding: This is based on your taxable income, filing status, and W-4 allowances or adjustments.
- State and Local Income Tax Withholding: Not all states impose an income tax, but those that do typically require employers to withhold a portion of wages.
- FICA Taxes (Social Security and Medicare): Employers withhold 6.2% for Social Security and 1.45% for Medicare. Employers also match these amounts.
- Additional Medicare Tax: An extra 0.9% is withheld on wages above $200,000 for single filers ($250,000 for joint filers).
- Other Withholdings: Depending on your situation, your employer may also withhold money for things like wage garnishments, 401(k) contributions or insurance premiums.
The IRS uses information from your W-4 form — such as your filing status, income level, dependents and additional income — to determine how much federal income tax to withhold from each paycheck. Your employer applies this information alongside IRS withholding tables to arrive at the appropriate amount. You can update your W-4 at any time during the year to reflect changes in your income, marital status, or number of dependents. This can help you keep your withholding more accurate and aligned with your actual tax obligation. Tax withholding helps taxpayers avoid a large year-end tax bill or underpayment penalties. However, it’s not a one-size-fits-all system. If your financial situation is more complex, such as having multiple jobs, freelance income, or significant deductions, you may need to fine-tune your W-4 or make additional adjustments. Failing to withhold enough could result in an unexpected tax bill and potential underpayment penalties. On the other hand, over-withholding could mean giving the government an interest-free loan throughout the year. The goal is to strike a balance, having just enough withheld to cover your tax liability without significantly impacting your monthly cash flow. There are also a few general guidelines to keep in mind: While employers automatically deduct tax withholdings from wages and salaries, individuals who receive income not subject to withholding use the estimated tax. This typically includes: Estimated tax payments are made quarterly using IRS Form 1040-ES. If you’re self-employed or have significant non-wage income, you’re responsible for calculating and paying estimated taxes on your own. Here are the key differences to keep in mind: If you have both types of income (e.g., you work full-time and also freelance), you may need a combination of accurate withholding and estimated tax payments to avoid penalties and stay current with the IRS. Whether you’re a salaried employee or a small business owner, knowing how much is being withheld and why can help you make informed decisions throughout the year. Keeping your W-4 form up to date, monitoring your income sources and working with a financial advisor can ensure that your withholding aligns with your actual tax liability. That way, you can avoid large refunds or unexpected bills and keep your financial plans on track. Photo credit: ©iStock.com/simpson33, ©iStock.com/Chalirmpoj Pimpisarn, ©iStock.com/Daenin Arnee Read the full article hereHow Is Withholding Tax Calculated?
Understanding Tax Withholding
Withholding Tax vs. Estimated Tax
Bottom Line
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