Understanding The U.S. Tax Withholding System
As we all know that Income taxes aren’t always withheld from people’s paychecks. In fact, income tax withholding is a relatively recent development.
Tax withholding first occurred in 1862 under Abraham Lincoln for the purpose of helping to finance the Civil War. The federal government also implemented a plethora of excise taxes for the same purpose.
How Does Tax Withholding Work?
In the early days of the income tax, when there was no withholding, people paid their full income tax bills for the previous year once a year on March 15, or in quarterly installments. Under today’s tax withholding system, taxes are collected at the source. This means that wage earners never see the money that they owe in taxes – it’s taken by their employers out of their paychecks and transmitted directly to the federal government.
The amount of income tax that is withheld from each paycheck depends on how an employee fills out IRS form W4. This form is not submitted to the government – it is only used by the employee and the employer to determine how much tax to withhold. Form W4 includes a worksheet that taxpayers use to determine their withholdings, based on the number of jobs they hold, marital status and dependents.
With today’s system, only the wages earned by employees are subject to withholding (for the most part). There are many other ways of earning income, however. Independent contractors aren’t subject to withholding, and neither is the income earned by investors. The 90% rule still applies, but individuals are responsible for calculating and remitting their own tax payments on a quarterly basis.
An exception to this rule arises if an individual becomes subject to backup withholding. If a taxpayer hasn’t paid his taxes in the past, or the name and Social Security number s/he reported don’t match, independent contractor and investment income (and some other uncommon categories of income) become subject to backup withholding at a rate of 28% (as of 2009). This situation is rare, though – most Americans are exempt from backup withholding.
The federal withholding system provides the model that 41 states use to withhold state income taxes – nine states: Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming don’t have a state income tax. Some states use IRS Form W4, while others have their own withholding worksheets.
Form W4 doesn’t give taxpayers a way to actually see how much income will be withheld from each paycheck. A good way to get a clear picture of how claiming different numbers of exemptions on form W4 will affect your income tax withholding is to use an online calculator.
To make sure you’re having at least 90% of the tax owed withheld from your paychecks, and to make sure you aren’t having too much withheld, use the tax withholding calculator at the IRS website. You can submit a new W4 to your employer to change your withholding at any time.
Conclusion
Most of us take the tax withholding system for granted, but it’s not really a given. It has come and gone over the years with the government’s desire to finance expensive projects and wars, and in response to the reactions of taxpayers to the system. Understanding how the system works will help you make informed decisions about both your political views and your personal finances.