What Is Withholding Tax? Types and How It's Calculated

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Withholding tax is income tax that a payer deducts from a payment before the recipient receives it and sends directly to the government. In the United States, the most familiar case is the federal income tax an employer takes out of each paycheck and remits to the Internal Revenue Service in the employee’s name. The amount withheld is not a separate tax. It is a prepayment that counts as a credit against the income tax the person owes for the year. When the return is filed, that credit is compared with the actual liability, producing either a refund or a balance due.

How withholding tax works

The U.S. income tax runs on a pay-as-you-go basis: tax is collected at the source as income is earned, not in one payment at year end. Withholding is the main tool for this on wages.

The process for an employee follows a fixed cycle:

1. Form W-4. When you start a job, you give your employer a W-4 (Employee’s Withholding Certificate). It shows your filing status, whether you hold multiple jobs or your spouse works, any dependent credits you expect, and optional adjustments for other income, deductions or extra withholding.
2. Each pay period. The employer applies IRS withholding methods to your gross pay and W-4 entries, deducts federal income tax and shows the deduction on your pay stub.
3. Deposit. The employer deposits the withheld amounts with the IRS on a set schedule, where they are recorded as tax paid on your behalf.
4. Form W-2. After the year ends, the employer sends you a W-2 (Wage and Tax Statement) showing total wages and total tax withheld.
5. Tax return. You calculate your actual tax liability and subtract the withholding shown on your W-2. The difference is your refund or your amount due.

Most states with an income tax run their own withholding systems alongside the federal one, using the federal W-4, their own state form, or both. Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Wyoming and Washington do not tax wage income.

What “subject to withholding” means

A payment is subject to withholding when the payer is legally required to withhold tax from it. Employee wages are subject to income tax withholding and FICA. Payments to independent contractors generally are not, unless backup withholding applies. Interest and dividends paid to U.S. residents usually are not, while the same income paid to a nonresident alien often is.

Types of withholding tax

Federal income tax withholding on wages

This is the deduction most people mean by withholding tax, and every U.S. employer must withhold it from employee wages. Its size depends on how much you earn, how often you are paid, your filing status and the adjustments on your W-4. The W-4 was redesigned for 2020 and now asks for dollar amounts instead of withholding allowances.

FICA: Social Security and Medicare

Payroll withholding also includes Federal Insurance Contributions Act taxes, which fund Social Security and Medicare. Unlike income tax withholding, FICA does not depend on your W-4 or filing status. It is a flat percentage of wages:

• Social Security: 6.2% of wages up to an annual wage base that the Social Security Administration adjusts each year.
• Medicare: 1.45% of all wages, with no cap. An Additional Medicare Tax of 0.9% is withheld on wages above $200,000 paid by a single employer in a year.

The employer pays a matching 6.2% and 1.45% from its own funds. FICA withheld is generally not refunded at filing time the way excess income tax withholding is, because it is a separate tax rather than a prepayment of income tax.

Withholding on supplemental wages

Bonuses, commissions and similar pay can be withheld at a flat federal rate of 22% instead of through the regular calculation, or 37% on supplemental wages over $1 million in a year. This is only a withholding rate. Your bonus is ultimately taxed at the rates that apply to your total income, so a large bonus can lead to a refund or a balance due later.

Backup withholding

Payments that normally have no withholding, such as interest, dividends or contractor fees, can become subject to backup withholding at 24%. It applies when the payee fails to provide a correct taxpayer identification number (which is why payers request a Form W-9) or when the IRS notifies the payer that the payee underreported interest or dividends. Backup withholding is credited against the payee’s tax at filing.

Nonresident withholding

A nonresident alien is a person who is not a U.S. citizen or national and has met neither the green card test nor the substantial presence test. U.S.-source income paid to nonresident aliens, such as dividends from U.S. companies, certain interest, royalties and rents, is generally subject to withholding at a flat 30% rate. A tax treaty between the person’s country and the United States can reduce or eliminate that rate. The recipient usually claims treaty benefits by giving the payer Form W-8BEN.

Other countries apply the same principle. Canada, for example, withholds tax on many payments to non-residents through the Canada Revenue Agency. Foreign tax withheld from a U.S. investor’s foreign dividends can often be claimed as a foreign tax credit on the U.S. return.

How withholding tax is calculated

Employers use the methods in IRS Publication 15-T, either the wage bracket method (lookup tables) or the percentage method (a formula). The percentage method follows these steps for federal income tax:

1. Take gross wages for the pay period and subtract pre-tax deductions, such as traditional 401(k) contributions or certain health premiums.
2. Annualize the result by multiplying by the number of pay periods in a year.
3. Add any other income the employee entered on the W-4 and subtract any deductions they entered.
4. Find the tentative annual withholding using the IRS table for the employee’s filing status (and the multiple-jobs adjustment if checked).
5. Subtract the annual credit amount from the W-4 dependents step.
6. Divide by the number of pay periods.
7. Add any extra per-period withholding the employee requested.

FICA is simpler: multiply covered wages by 6.2% and 1.45%, stopping Social Security at the wage base.

Example of withholding tax

Hypothetical example. The income tax figure below is assumed for illustration, not taken from current IRS tables.

Maria is paid biweekly (26 pay periods). Her gross pay is $2,000 per period, with no pre-tax deductions, and she files as single with no W-4 adjustments.

Over the year, her employer withholds $160 × 26 = $4,160 in federal income tax, and her W-2 reports that total.

Now suppose her return shows a federal income tax liability of $3,800. Her withholding exceeds the liability by $360, so she receives a $360 refund. If the liability were instead $4,500, she would owe $340 when filing.

If Maria also received a $5,000 bonus paid separately, her employer could withhold $1,100 of federal income tax from it at the 22% supplemental rate. That $1,100 is added to her $4,160 total and credited the same way.

Interpreting your withholding

Your refund or balance due measures how closely withholding tracked your liability, not how much tax you paid. A large refund means you lent the government money interest-free during the year. A balance due means withholding fell short.

Falling too far short can cost more than the tax itself. The IRS charges an underpayment penalty unless withholding and timely estimated payments cover at least 90% of the current year’s tax or 100% of the prior year’s tax (110% if prior-year adjusted gross income exceeded $150,000), or unless the balance due is under $1,000. Withholding counts as paid evenly through the year, so increasing it late in the year can still help avoid the penalty.

Review your withholding early in the year and after changes in tax law or your circumstances, such as marriage, divorce, a new child, a second job, a large raise, or new deductions and credits. The IRS Tax Withholding Estimator uses your pay and withholding figures to project a refund or bill and suggest W-4 changes.

Why withholding tax is important

Withholding gives the government steady revenue through the year and reduces tax evasion, since a third party reports and pays the tax before the earner can spend the money. For individuals, it spreads income tax across every paycheck instead of leaving one large bill in April.

Limitations of withholding tax

• It is an estimate. Employers see only the wages they pay and your W-4. Two jobs, a working spouse, or sizable investment or side income can leave you under-withheld unless you account for them.
• It doesn’t cover everyone. Self-employed people, independent contractors and many investors have no withholding on most of their income and must make quarterly estimated tax payments instead.
• Corrections take time. A new W-4 only affects future paychecks. When an employer wrongly withholds and fails to correct it, Form 843 can be used to request a refund of the over-withholding.
• Flat-rate withholding can mismatch. The 22% supplemental rate and the 30% nonresident rate ignore the recipient’s full situation, so the final tax can differ significantly.

Who can claim exemption from withholding

An employee can claim exemption from federal income tax withholding on Form W-4 only if they had no federal income tax liability in the prior year and expect none in the current year. The exemption lasts for one calendar year; to continue it, the employee must submit a new W-4 claiming exemption, generally by February 15 of the following year. Claiming exempt status stops income tax withholding only. Social Security and Medicare are still withheld.

FAQs

The Bottom Line

Employees, people with multiple jobs or side income, and anyone receiving bonuses should check that withholding tracks their actual liability. A large refund is an interest-free loan to the government, while a shortfall can bring an underpayment penalty. Reviewing your W-4 early in the year and after life changes, with help from the IRS Tax Withholding Estimator, keeps withholding close to what you owe.