Tax Withholding: What It Is And How It Works

KEY TAKEAWAYS

• Tax withholding breaks your income tax payments up into smaller portions, paid each pay period. 
• Your employer pays that money on your behalf to the IRS as part of the pay-as-you-go tax collection system.
• The 2 types of federal withholding are U.S. Resident and Nonresident.
• The simplest way for an individual to calculate the amount is to use the Tax Withholding Estimator.

What Is Tax Withholding?

Tax withholding is the action of holding back income tax from a paycheck. It applies to regular pay, pensions, bonuses, commissions, and gambling winnings.

Employers must withhold employment taxes from your paycheck. The amount that gets held back depends on your earnings and the information you gave on your Form W-4. Federal income tax, social security, and medicare taxes make up your employment taxes.

The Internal Revenue Service provides an online Tax Withholding Estimator that you can use to confirm your employer is withholding the correct amount. You should review your withholding: 

• If the tax law changes
• When you have life changes
• At the beginning of each year

How Does Tax Withholding Work?

Your employer withholds income tax from your paycheck throughout the year and remits it directly to the Internal Revenue Service on your behalf. By taking a small portion each pay period, you lessen the shock of a huge tax bill at tax time. 

Withholding income tax doesn’t increase or decrease your tax liability; it spreads the money owed in smaller payments over a year. The amount withheld is calculated based on your income, filing status, and the withholding allowance on your W-4. 

Beginning with the 2020 W-4, employees are no longer able to request adjustments to their tax withholding using withholding allowances. Instead, employees provide employers with amounts to decrease or increase their tax withholding.

If your employer has you submit a W-4, they must withhold income taxes every pay period. You can have additional tax withheld from your paychecks if you have a second income not subject to employer tax withholding. 

Typically, sole proprietors, contractors, and those with other careers who do not pay through withholding, pay estimated taxes every quarter to lessen how much they owe for the year.

According to the Internal Revenue Service, it is a good idea to use the Tax Withholding Estimator tool to review your tax withholding each year and whenever you have:

• Major changes to your lifestyle including marriage, divorce, birth or adoption of a child, home purchase, retirement, filing for bankruptcy
• You or your spouse have a change in wage, start or stop working, or start or stop a second job
• Self-employment income, interest income, dividends, capital gains, IRA distributions, and other taxable income not subject to withholding
• IRA deduction, alimony expense, student loan interest deduction, or other adjustments to income 
• Medical expenses, dependent care expenses, gifts to charity, taxes, education credits, interest expenses, child tax credits, earned income credits, and other itemized deductions or tax credits

Change your federal tax withholding amount by completing sections 2 to 4 on a new W-4 and submit it to your payroll department, human resources, or employer.

Withholding Tax Types

The IRS outlines 2 types of withholding tax meant to ensure the collection of taxes owed. They are the U.S. Resident Withholding Tax and the Nonresident Withholding Tax.

U.S. Resident Withholding Tax

The U.S. Resident Withholding Tax is the IRS designation for the general withholding tax that applies to all U.S. residents. It specifically relates to the income earned by residents from U.S. employers and certain international sources. 

The IRS designated the following earnings as subject to tax withholding:

• Your regular pay, commissions, and vacation pay
• Reimbursements and other expense allowances paid under a nonaccountable plan
• Pensions, bonuses, commissions, gambling winnings, and certain other income 

Nonresident Withholding Tax

A nonresident alien or NRA is any foreign person with a U.S. source of income who is not a U.S. citizen or a U.S. national. NRAs include: 

• Temporary workers or tradespeople
• Foreign entities
• Governments
• Anyone conducting business in the U.S. as a nonresident 
• People who have not passed a green card test or substantial presence test

Through withholding, the IRS can capture the applicable taxes through a pay-as-you-go collection system. The NRA withholding tax rate is a flat 30% (or lower treaty rate). There are some cases when a reduced rate or exemption applies. For example, if there is a tax treaty between the foreign person’s country of residence and the United States.

Nonresidents must file Form 1042 and related Form 1042-S for the year they engage in trade or business in the United States.

Calculating Tax Withholding

Your withheld tax includes Medicare and Social Security tax, and federal income taxes. The amount withheld from your paycheck depends on how much you earn and the information you gave on your Form W-4. 

Your employer uses the most recent tables to calculate the amount of income tax to withhold. They will add or subtract adjustments you entered on your Form W-4 (extra withholding amount or deductions), then apply the applicable tax to the total amount.

There is a benefit to adding an extra withholding amount on your W-4. The main benefit is it can ensure you won’t have a surprise tax bill when you file your federal income return. In some cases, you may even have a tax refund. The downside is you won’t have that money in your pocket during the year.

Use the Tax Withholding Estimator to calculate what amount to enter in Step 4, Extra Withholding on your Form W-4. To use the estimator, you need the following information on hand: 

• Your filing status
• Your income and any additional income
• Your pay stub information, including the end date of your most recent pay period, your per-period wages and year-to-date (YTD) totals, the amount of federal income tax per pay period, and the total paid year-to-date

You also need to know the amount of any applicable tax credits and whether you take the itemized or standardized deductions. If you file jointly, you also need this information from your spouse. Both you and your spouse must use the same deduction method if you file jointly. Entering incorrect information can impact your year-end tax liability and potential tax refund.

The table below outlines the 2023 Marginal Tax Rate used to calculate your withholding tax.

 Source IRS.gov

Simplify Tax Preparation With Freshbooks

Tax withholding can be useful if you have the right information. If you increase your withholding allowance or make estimated payments, you can further decrease your end-of-year tax burden. Review your tax situation by using the Estimator today.

FreshBooks offers many articles and guides to help you and your small business through payroll, invoicing, filing tax returns, and more. FreshBooks accounting software can track and categorize expenses to help you capture every eligible deduction. Try FreshBooks free by signing up today to see how easy tax filing can be!

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.