Withholding Tax Explained: Types and How It's Calculated

What Is Withholding Tax?

The term "withholding tax" refers to the money that an employer deducts from an employee’s gross wages and pays directly to the government. The amount withheld is a credit against the income taxes the employee must pay during the year.

The vast majority of people who are employed in the United States are subject to tax withholding. Nonresident aliens are also subject to withholding taxes on earned income as well as on other income such as interest and dividends from the securities of U.S. companies that they own.

Understanding Withholding Tax

Tax withholding is a way for the U.S. government to maintain its pay-as-you-go (or pay-as-you-earn) income tax system. This means taxing individuals at the source of income rather than trying to collect income tax after wages are earned. 

Here's How It Works

Whenever an employee gets paid, their employer withholds a certain percentage of their paycheck as income tax. This is then paid by the employer to the Internal Revenue Service (IRS).

The amount deducted appears on the employee's paystub and the total amount deducted annually can be found on Form W-2: Wage and Tax Statement. Employers send W-2s to their employees each year to help them file their annual income tax returns.

The amount deducted depends on a number of factors. These considerations include the amount an employee earns, filing status, any withholding allowances claimed by the employee, and whether an employee requests that additional income be withheld. If merited, any excess is paid back to the employee by the IRS as a tax refund.

Special Considerations

The majority of U.S. states also have state income taxes and employ tax withholding systems to collect taxes from their residents. States use a combination of the IRS W-4 Form and their own worksheets, which residents fill out to establish their withholding.

Nine states do not impose income tax on residents. They are: Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Withholding tax only applies to capital gains for high-earners living in Washington.

New Hampshire residents pay tax on interest and dividend income only. However, they voted to gradually phase out this practice by 2027.

History of Withholding Taxes

Tax withholding first occurred in the U.S. in 1862 at the order of President Abraham Lincoln to help finance the Civil War. The federal government also implemented excise taxes for the same purpose. Tax withholding and income tax were abolished after the Civil War in 1872.

The current system was accompanied by a large tax hike when it was implemented in 1943. At the time, it was thought that it would be difficult to collect taxes without getting them from the source. Most employees are subject to withholding taxes when they are hired and fill out a W-4 Form. The form estimates the amount of taxes that will be due.

The withholding tax is one of two types of payroll taxes. The other type is paid to the government by the employer and is based on an individual employee’s wages. This money contributes to funding for Social Security and federal unemployment programs (since the Social Security Act of 1935) as well as Medicare (since 1966).

Types of Withholding Taxes

There are two types of withholding tax employed by the IRS to ensure that proper tax is withheld in different situations: the U.S. resident and nonresident withholding tax.

U.S. Resident Withholding Tax

The first and more commonly discussed withholding tax is the one on U.S. residents’ personal income, which every employer in the U.S. must collect. Under the current system, employers collect the withholding tax and remit it directly to the government, with employees paying the remainder of what they may owe when they file a tax return in April each year.

If too much tax is withheld, the result is a tax refund. However, if not enough tax has been held back, then the individual will owe money to the IRS.

Generally, you want about 90% of your estimated income taxes withheld and sent to the government. This ensures that you never fall behind on income taxes (something that can result in heavy penalties) and that you are not overtaxed throughout the year.

Investors and independent contractors are exempt from withholding taxes but are required to pay quarterly estimated tax. If these classes of taxpayers fall behind, they can become liable to backup withholding, which is a higher rate of tax withholding set at 24%.

You can easily perform a paycheck checkup using the IRS’s tax withholding estimator. This tool helps identify the correct amount of tax withheld from each paycheck to make sure that you don’t owe more when you file your annual return.

To use the estimator, you'll need your most recent pay stubs, your most recent income tax return, your estimated income during the current year, and other information.

Nonresident Withholding Tax

The other type of withholding tax is levied against nonresident aliens to ensure that proper taxes are paid on income sources from within the U.S. A nonresident alien is someone who is foreign-born and has not passed the green card test or a substantial presence test.

All nonresident aliens must file Form 1040NR if they are engaged in a trade or business in the U.S. during the year. If you are a nonresident alien, there are standard IRS deduction and exemption tables to help you figure out when you should be paying U.S. taxes and which deductions you may be able to claim. If there is a tax treaty between your country and the United States, that can also affect withholding tax.

Calculating Your Withholding Tax

The IRS updates marginal tax rates annually. The rates for tax year 2024 are highlighted in the table below:

You can calculate your withholding tax by using the IRS Withholding Estimator. In order to get an accurate figure, you'll need some basic information. Be sure to have the following handy when you're filling out the online form:

• Your filing status
• Your income source
• Any additional income sources
• The end date of your most recent pay period
• Your wages per period and the year-to-date (YTD) totals
• The amount of federal income tax per pay period and the total paid year-to-date
• Whether you take the standard deduction or itemize your deductions
• The amount of any tax credits you take
  

The estimator tells you how much of a refund or tax bill you can expect. You can also choose an estimated withholding amount that's suitable for you.

The Bottom Line

Withholding tax is the amount of money that your employer holds back from your paycheck and sends to the government as payment toward your income taxes. Anyone who earns income is responsible for paying income tax.

You could get a tax refund after filing your taxes, or you may owe more money. Part of your tax bill depends on your withholding tax.

If you find that you end up paying more money on tax filing day, you can lower that amount by requesting that additional money be held from your paycheck. On the other hand, having a smaller amount deducted from every paycheck may make it easier to satisfy your tax bill at the end of the year.