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What is Withholding Tax?

A W-2 wage and tax statement states how much an employee was paid and how much in taxes was withheld.
A lottery winner will be charged a withholding tax.
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  • Written By: Tricia Ellis-Christensen
  • Edited By: O. Wallace
  • Last Modified Date: 21 July 2014
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A withholding tax is an amount of money deducted straight from money you’d normally be paid, most often by employers, but occasionally by financial institutions, or if you’re lucky enough, from a large jackpot in a lottery. For the basic paycheck, the employer uses the withholding tax to pay taxes to a government. In the US, this can mean employers withhold taxes to pay the Internal Revenue Service, and in states where there is a tax on income, employers may also use a withholding tax to pay state taxes. Money is additionally withheld to make contributions to Social Security.

In the US, both federal and state withholding tax tends to be determined by two factors: the amount of income you make and the number of exemptions you take. If people don’t feel their year’s salary is going to require them to pay much in tax, particularly if their income falls below the poverty level, they may claim the maximum number of exemptions in order to reduce amounts taken from their paycheck. This way they have access to the majority of their money immediately, rather than having to wait until the end of the year to claim a refund on taxes paid.

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Alternately people may raise their exemption number if they have new dependents to support, or if a spouse loses a job. On the other hand, taking too many exemptions can mean that when you file your taxes at the end of the year, you’ll end up owing the government money. Though you often are allowed to take as many exemptions as you’d like, this isn’t always prudent. For instance, if one spouse works as a freelancer, and the other spouse works for a company, you may be able to offset some of the taxes owed by the freelancer (including social security income) by claiming a lower number of exemptions. More money will be withheld to pay taxes, but you could end up owing little to nothing in taxes on the freelancer spouse’s income at the end of the year.

Typically, contract workers and freelancers do not pay withholding tax. It’s their responsibility to claim their income at the end of the year and make the necessary payments. It makes sense to make an estimate of your taxes for the year and set aside that money to pay year-end taxes. The benefit to withholding your own taxes is that you can drop this money into a savings account and earn a little interest. Others file a quarterly tax report and prepay taxes in order to make sure they aren’t hit with a huge payment request at the end of the year.

For guidelines on how many exemptions you should claim to pay the appropriate withholding tax, your best bet in the US is either to speak to a well-informed payroll employee or your human resources department. You can also call the Internal Revenue Service or your state tax board to estimate the best number of exemptions to claim or to arrange for making advance tax payments if you freelance. Remember that everything changes if your salary increases. Always check back with any of the above-mentioned sources to see if you should change your exemptions. Many employers allow you to change exemptions at any time, or on a monthly basis.

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Discuss this Article

ellaesans
Post 3

@Sunny27 - My husband and I own a company and we pay quarterly. However, I'm also employed as a freelancer and work with a W-9 or on a 1099 at the end of the year, so we as individuals file at the end of the year as well as quarterly for our business. When we file quarterly, we itemize all of our business expenses, which helps a lot to offset the taxes owed.

Aside from that, I itemize any expenses I can for my freelance work (within reason) and we almost always end up taking the whole mess to a professional. It tends to get a little confusing so my suggestion is that anyone working for an employer that does -not- provided tax withholding is to go ahead and take care of it with a professional. Otherwise, you might be in for a ride!

leiliahrune
Post 2

@Sunny27 - I agree with the aspect of setting aside funds yourself as well when you're working off a 1099. You should always overestimate taxes if you can because it will be like getting a refund or it can help if you run into something unexpected - like in the case that you might owe more.

Sunny27
Post 1

Great article- I agree that estimating taxes and setting aside such funds is necessary for independent contractors. Some contractors pay quarterly installments of taxes instead of one lump sum at the end of the year.

This helps with the tax planning and makes it easier because the contractor has a better idea of what to expect at the end of each quarter. That is what I do and it works for me.

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