Withholding Tax

The amount legally deducted from an employee's wages or salary by the employer, who uses it to prepay the charges imposed by the government on the employee's yearly earnings.

The federal Income Tax system is a "pay-asyou-go" system that requires wage earners to pay federal tax as they earn income. The federal government enforces this system through a withholding tax on wages and salary income. A taxpayer who does not have enough tax withheld may be subject to penalties for underpayment.

In 1942 the federal government instituted a one-time withholding tax as a revenue-raising device during World War II. Withholding taxes are now a permanent method of collecting income taxes at the state and federal levels. Each pay period an employer is required to withhold tax from each employee's gross salary and send it to the Internal Revenue Service (IRS) and to the state revenue collection agency, if the state has an income tax.

When a person is hired for a salaried job, the new employee must complete a federal W-4 form, which authorizes the employer to retain a certain amount of the employee's earnings to be forwarded to the government to satisfy the employee's federal income tax liability. The W-4 consists of a certificate showing the withholding allowances claimed by the employee and a worksheet in the form of an abbreviated tax return. The employee estimates her income, deductions, credits, and exemptions to determine how many withholding allowances to claim. The more allowances claimed, the less tax is taken out each pay period. The goal is to have the withheld taxes equal the yearly tax liability.

Taxpayers who underestimate the withholding tax needed to satisfy their tax liability may have to pay a penalty for underpayment. The IRS encourages taxpayers to review their financial situation periodically and file amended W-4 forms.

Backup withholding is a way of assuring that tax is paid on dividend and interest income. If a taxpayer does not provide his Social Security number to the payer of dividend or interest income, such as a bank, the institution must withhold a "backup" of 31 percent of each payment until the taxpayer provides the number.