Withholding Tax 101: What It is and How to Calculate It
February 27, 2023
Withholding tax is a term that’s quite familiar to every wage earner and salaried employee. It refers to the amount employers retain from employee wages to ensure their taxes are duly paid.
But what percentage of employee earnings go to withholding taxes? How do employers determine the amount to be withheld and remitted to the IRS?
More importantly, are there withholding tax exemptions, and if there are, who is entitled to these conditions?
Keep reading to answer all these questions and understand all there is to know about withholding tax!
- Withholding tax is the amount withheld by employers from employee earnings and then remitted directly to the IRS.
- Income taxes were first imposed in 1862 to help the government collect funds for the ongoing civil war.
- The current tax withholding system was put into place in 1943, after multiple movements to repeal and revamp tax laws.
- The two main classifications of withholding taxes are the United States Withholding Tax and Non-resident Withholding Tax.
- Other types of payroll and withholding taxes include federal income taxes, state and local taxes, Social Security, Medicare, FUTA, and SUTA.
- To calculate your withholding taxes, you need to check the tax brackets for 2023, review all your tax details, and use the IRS Tax Withholding Calculator.
What is Withholding Tax?
Withholding tax refers to the amount set aside by employers from employee earnings and then transmitted directly to the IRS. It includes federal and state taxes, and Social Security and Medicare taxes (FICA).
Generally, all US residents and even non-resident aliens are subject to withholding tax for as long as their earnings and other income sources, such as dividends, corporate bonds, or term deposits, are generated from US-based companies or sources.
The smaller the amount withheld from your earnings, the more tax you will owe to the IRS later on. But if there is an excess of withheld tax, you may be entitled to a tax return.
Taxpayers may be exempt from withholding tax, provided that they do not owe the IRS any federal income tax from the previous tax year and are not expecting any federal income tax for the upcoming tax year.
In such cases, they may claim their exempt status on their Form W-4. Investors and independent contractors are exempted from withholding taxes. However, they are not excluded from contributing to quarterly estimated income tax.
Withholding Tax History
In the past, taxpayers paid their income taxes for the previous year in full in March. They were also allowed to pay their taxes on a quarterly basis.
Withholding taxes is said to have started in 1862, during the reign of then-president Abraham Lincoln. His party began withholding taxes and imposing excise taxes as a means to fund the ongoing civil war.
In 1872, withholding tax was abolished, only for income taxes to be made permanent in 1913 following the ratification of the 16th amendment. Unfortunately, this led to widespread criticism from employers since the responsibility of collecting taxes was passed on to them, doubling the workload they had to accomplish.
Albeit the repeated repealing of withholding laws in the US, it persistently found its way back into passing, particularly after the Social Security Act was passed in 1935. Then, the tax withholding system was invented in 1943 and imposed on both the rich and the common people.
Presently, the government has adopted the pay-as-you-go tax system, wherein taxes are paid as income is received by workers or employees.
Different Types of Tax Withholding
There are two main classifications of tax withholding: United States Resident Withholding Tax and Non-resident Withholding Tax. We’ll thoroughly cover them both in the section below.
#1. United States Resident Withholding Tax
The United States Resident Withholding Tax refers to the tax imposed on interest generated from bank accounts and various investments. Royalties, reimbursements for services, rents, and annuities are also subject to tax deductions under the US Resident Withholding Tax.
This specific tax is deducted either by the bank or the organization where the taxpayer has invested assets or money. If companies have shareholders, they may also withhold taxes from dividends.
Tax withholding takes place each time the bank or investment firm credits interest to the account holder or investor. Tax rates for Resident Withholding Tax typically vary depending on the business type and the investor.
#2. Non-resident Withholding Tax
Non-resident Withholding Tax is a type of tax prepayment mandated on non-residents of the US.
The said tax is often deducted from royalty interest revenue generated from oil and natural gas. It is meant to supply the state with a percentage of earned revenue from gas and oil fees.
Among the specific states that impose Non-resident Withholding Tax include California, Georgia, Montana, New Mexico, North Carolina, Oklahoma, Oregon, Utah, and Wisconsin. Alternatively, states that do not impose Non–resident Withholding have set deductions on S corporations and partnerships that have shareholders who are not residents of the US.
Other Types of Payroll and Withholding Tax
Aside from Non-resident Withholding Tax and United States Resident Withholding Tax, the following are the other types of payroll and withholding taxes:
- Federal Income Tax. This tax is otherwise called progressive or marginal tax. The IRS levies federal income tax on all types of earnings, such as salaries or wages, bonuses, and commissions, income earned through investments, and tips.
- State Income Tax. State income tax is levied on income earned by residents in the state where they are located. Each state in the US follows different withholding tax regulations.
- Local Income Tax. This type of tax supplements both federal and state income taxes. It is imposed by the local authorities in a specific locale or area, particularly those that also impose a state income tax.
- Medicare. Medicare tax is a federal health insurance created for people aged 65 and above and individuals under 65 with underlying health conditions and disabilities.
- Social Security. Social Security Tax is levied to help fund retirement benefits.
- FUTA (Federal Unemployment Tax Act). FUTA taxes are imposed to provide resources for the federal government’s unemployment programs.
- SUTA. This is the state-wide version of FUTA. SUTA deductions vary per state.
How to Calculate Your Withholding Tax
To calculate your withholding tax, first you need to know the tax brackets for 2023. See the table below for tax brackets for singles and married couples filing individually:
Tax Bracket for Single and Married Couples Filing as Individuals (2023)
35% for incomes amounting to more than $231,250
32% for incomes amounting to more than $182,100
24% for incomes amounting to more than $95,375
22% for incomes amounting to more than $44,725
12% for incomes amounting to more than $11,000
10% for incomes amounting to more than $11,000
The table below is for married couples filing together:
Tax Bracket for Married Couples Filing Jointly (2023)
37% for incomes amounting to more than $693,750
35% for incomes amounting to more than $462,500
32% for incomes amounting to more than $364,200
24% for incomes amounting to more than $190,750
22% for incomes amounting to more than $89,450
12% for incomes amounting to more than $22,000
10% for income less than $22,000
Next, you need to take note of the following:
- Filing status
- Source(s) of income
- End date of last pay period
- Total earnings per pay period
- Year-to-date (YTD) totals
- Federal income tax rates per pay period plus total taxes paid year-to-date
- Deductions (standardized or itemized)
- Tax credits taken
List all that information before opening the IRS Tax Withholding Estimator. By using this handy tool, you can determine your upcoming tax rates and check whether you may be entitled to a tax refund.
Withholding tax simplifies and automates the process needed to collect taxes. In truth, it benefits the government more than it does the taxpayers.
However, paying taxes is a civic responsibility. It is a mandate that applies to all residents, even non-US residents. Thus, it is essential to ensure you do not miss any tax dues. Lastly, understanding how withholding tax works lets you know whether you are entitled to a tax refund, are tax-exempt, or if you owe any taxes.