Tax withholding refers to the portion of an employee's gross wages that is retained by an employer for remittance to the Internal Revenue Service (IRS). Two main types of taxes are typically withheld—regular income taxes and Federal Insurance Contribution Act (FICA) taxes, which include contributions to the federal Social Security and Medicare programs. Many states and some cities and municipalities also apply taxes and in some cases these taxes too must be withheld by employers.
At the federal tax level, the two types of taxes that employers are required to withhold are amounts for regular income taxes and a set percentage of gross pay for FICA taxes.
The amount that is withheld from an employee's paycheck in order to pay income taxes is determined based on the person's income level and the number of exemptions that the person claims. Withholding is usually done in standard amounts based on formulas provided by the IRS. Employees can adjust their income tax withholding by filing Form W-4 with their employer and designating the number of withholding allowances they wish to claim. Employees decide upon the number of withholding allowances they wish to claim based on their expected tax liability, which depends on their filing status, family circumstances, other sources of income, and available deductions or tax credits. It is not advisable to overpay taxes—even though the extra amount is eventually refunded to the taxpayer—because it is like giving the government an interest-free loan. At the same time, it is not advisable to underpay taxes because it may be difficult to come up with a lump-sum payment when it is due on April 15. In addition, a taxpayer who underpays his or her income taxes by more than 10 percent may face a penalty and have to pay the government interest on the funds owed.
Unfortunately, the IRS guidelines for withholding can cause problems with overpayment or underpayment of taxes even in simple cases. For example, a single taxpayer with no dependents and only one source of income would be instructed to claim two withholding allowances to best approximate the total tax owed. But this strategy may cause the taxpayer in question to owe around $200 on April 15. Similarly, a married couple with one income would be instructed to claim three withholding allowances, but this would cause a balance due for the year of nearly $400. Because the IRS guidelines are general, some small underpayment or overpayment is likely even if the number of withholding allowances or exemptions is chosen with care.
There is another factor that needs to be considered when an employee decides about the number of exemptions to choose, and thus a tax withholding level. Many people supplement their regular employment income with interest, dividends, capital gains, rental property, or self-employment income. In many cases, this means that regular withholding from employment income—based on the IRS formulas—is not enough to cover the taxes owed. In a situation in which an employee anticipates income from other sources, he or she may choose to maximize the amount withheld by the employer so that the taxes withheld will help to pay for tax obligations arising from another source of income.
Taxpayers are required to pay at least 90 percent of their total tax liability in installments prior to April 15. If they do not, they may be subject to a penalty. However, the penalty is waived for taxpayers who pay at least as much in total taxes as they had owed the previous year, or for whom the amount underpaid is less than $500. Since the IRS calculates the amount owed quarterly, a large lump-sum payment in the fourth quarter will not enable a taxpayer to escape penalties. On the other hand, a significant increase in withholding in the fourth quarter may help, because tax that is withheld by an employer is considered to be paid evenly throughout the year no matter when it was withheld. For this reason, taxpayers who see a significant underpayment problem looming should have additional taxes withheld by their employers. An employee may request that his or her employer withhold and send to the IRS as large a percentage of his or her gross income as desired. So, for example, if a person who does Web site design work as a supplement to her regular job receives a large Web design project late in the tax year, she may ask her employer to increase her income tax withholding to 50 percent for the remainder of the year in order to try and make up for the unexpected rise in income tax liability for that year. To avoid a penalty, the total tax withheld must reach 90 percent of what will be owed in the current year or 100 percent of what was owed in the previous year.
This strategy can also work for a self-employed person who falls behind in his or her estimated tax payments. By having an employed spouse increase his or her withholding, the self-employed person can make up for the deficiency and avoid a penalty. The IRS has also been known to waive underpayment penalties for people in special circumstances. For example, they might waive the penalty for newly self-employed taxpayers who underpay their income taxes because they are making estimated tax payments for the first time.
The second type of federal tax which employers are required to withhold from their employees' payroll checks is the Federal Insurance Contribution Act (FICA) tax. The FICA tax includes contributions to two federal programs, Social Security and Medicare. The tax rate for FICA taxes does not often change but the earnings on which those taxes are applied changes from year to year. In 2006, full FICA taxes of 7.65 percent were due on the first $94,200 earned. Only the Medicare portion of the FICA tax, 1.45 percent, was due on earnings over $94,200. Employers are required to match the FICA amount withheld for every employee, so that the total FICA contribution is 15.3 percent on the first $94,200 earned. Self-employed persons are required to pay both the employer and employee portions of the FICA tax.
Employers are required to withhold 7.65 percent of the first $94,200 of an employee's income for FICA taxes. Employers are also required to match that amount for every employee, so that the total FICA contribution is 15.3 percent. Self-employed persons are required to pay both the employer and employee portions of the FICA tax. The amount of regular income tax that must be withheld from an employee's paycheck depends on the individual's tax status. Ideally, the total income tax withheld should come close to equaling the employee's overall tax liability at the end of the year. Employees can adjust their income tax withholding by filing Form W-4 with their employer and designating the number of withholding allowances they wish to claim.
Aaron, Henry J., and Joel Slemrod. Crisis in Tax Administration. Brookings Institute Press, December 2003.
"Bad Health Will Not Excuse Penalty for Unpaid Payroll Tax." The Kiplinger Tax Letter. 10 March 2006.
Bieg, Bernard J. Payroll Accounting 2005. Thomson South-Western, November 2004.
Daily, Frederick W. Tax Savvy for Small Business. Nolo, November 2004.
Fishman, Stephen. Deduct It!: Lower Your Small Business Taxes. Nolo, September 2005.
Grassi, Carl. "Federal Withholding Rules Enforced with an Iron Fist." Crain's Cleveland Business. 12 June 2000.
Longenecker, Justin G., Carlos W. Moore, J. William Petty, and Leslie E. Palich. Small Business Management with Infotrac: An Entrepreneurial Emphasis. Thomson South-Western, 2005.
U.S. Department of the Treasury. Internal Revenue Service. "What is the difference between a Form W-2 and a Form 1099-MISC?" Available from http://www.irs.gov/faqs/faq12-2.html. Retrieved on 1 May 2006.