'Withholding Tax' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Withholding Tax refers to the U.S. Federal income tax which they withhold from the wages of any employee. Employers pay these taxes which they collect from their employees’ payrolls straight to the government. All amounts which they withhold become credited against the employees’ income taxes. This offsets the amount the employees owe throughout the calendar year. This tax is similarly assessed on other forms of income, including dividends, capital gains, and interest earned by any securities the individual holds. Even non-residents who are American citizens will have to pay these taxes.
The Internal Revenue Service utilizes two different forms of Withholding Taxes in their efforts to be certain that the correct amount of taxes become withheld in various scenarios. By far and away the most commonly utilized and talked about one is the standard means of withholding against personal income. All U.S.-based employers are required to do this on behalf of their employees, whether they are part time or full time. The second and less common method pertains to those nonresidents of the U.S. who earn money in the United States. Their income similarly must be levied to ensure that Uncle Sam receives his full due.
By engaging in Withholding Tax procedures, the United States Department of the Treasury is able to go straight for their share of taxes right at the income source, instead of trying to collect their income taxes after the fact once they are already earned (and potentially spent). They originated this clever, forward thinking system back in 1943 as they instituted a massive tax hike on Americans. Back in the day, the government pondered the issue and believed that they would find it hard to gather up such a huge percentage of income in taxes if they did not get them upfront.
The vast majority of employees fall under the legislation that withholds the taxes when they become hired. The IRS requires all employers to obtain a completely filled in Form W4 at this point before their new employees can receive their first paycheck. This form is utilized to estimate the proper amount of taxes the employee will owe throughout the year and per payroll.
For the majority of people in normal circumstances, they need to have approximately 90 percent of their estimated income taxes be withheld by the Internal Revenue Service this way. Otherwise, they will probably fall behind on the taxes. This oversight comes with stiff penalties. The system is also designed to not overtax individuals as they are paying along the way throughout the year.
Both independent contractors and investors have an exemption from the tedious procedures of Withholding Tax. This does not in any way exempt them from paying the income tax though. When such taxpayers as these get behind on their tax withholding and payment, they can be subjected to backup withholding. This involves a steeper tax rate of withholding that the government sets at a punishing 28 percent.
As if this was not difficult and confusing enough, fully 41 of the individual 50 states utilize a similar withholding scheme for their state income taxes. This way they are sure that they will be able to levy and collect on their own taxes from the state residents. The states rely on both their own worksheets as well as the IRS’ Form W4 in order to estimate state income tax withholdings for the year and per paycheck. Nine of the states do not collect an income tax.
Such withholding tax is mandatory for the overwhelming majority of Americans or nonresidents who earn income off of a business or a trade within the U.S. Even Americans who live and earn money overseas cannot escape from their income tax obligations. Even nonresident American citizens living and working abroad will be assessed on foreign earned income as well.