What Is a Tax Withholding?

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DEFINITION
A tax withholding is an amount withheld from a payment such as a paycheck for tax purposes.

A tax withholding is an amount withheld from a payment such as a paycheck for tax purposes. This tax withholding can help you cover your tax liability throughout the year, rather than be hit with a surprise tax bill when it comes time to file taxes. Understanding tax withholding can help you optimize your taxes and your overall budgeting.

Definition and Examples of Tax Withholding

A tax withholding is money set aside from a payment in order to cover the taxes that are owed in association with that payment. In many cases, for example, your paycheck will be less than your full wages, since your employer has withheld some money to cover your tax liability. That money gets sent by your employer to relevant tax authorities, including the Internal Revenue Service (IRS).

Suppose you earn $2,000 per pay period. Instead of receiving $2,000, you receive a paycheck for $1,600, because your employer has set aside $400, or 20%, of your paycheck, as a tax withholding.

Actual withholding rates may differ, and other paycheck deductions, such as a pre-tax health insurance deduction, may complicate this math somewhat. In general, however, a tax withholding enables you to pay taxes with each paycheck. When it comes time to file your taxes, you can see whether this withholding was enough to cover your full tax liability.

In some cases, you might have not had enough tax withheld, so you would owe money to the IRS or other tax authorities. In other cases, you might have had too much tax withheld from your paychecks, such as if you ended up not earning as much as expected that year due to leaving your job. In that case, you might receive a tax refund.

In addition to your paycheck, tax withholding can also apply to other types of payments that might incur a tax liability, such as gambling winnings or Social Security benefits.

How a Tax Withholding Works

A tax withholding works by an employer or another type of payer holding back a portion of a payment to account for taxes. The exact amount withheld depends on several factors, such as income, deductions, and relevant tax rates. While the tax withholding is intended to account for tax liability, the amounts may not always align perfectly.

With a paycheck, for example, you will generally be asked to complete a W-4 form so your employer can figure out your federal tax withholding. This form will let you specify your circumstances, which helps determine how much should be withheld.

For example, if you have children you claim as dependents, you could add that information to your W-4 to reduce your tax withholding. However, if you don’t add this information to your W-4, it’s not as if you’ll ultimately pay more tax than you truly owe in the end. Instead, you could be eligible for a tax refund, because you may have had more tax withheld from your paycheck than what you end up owing for the year when it comes to filing.

On the flip side, if you claim more deductions on a W-4 than you’re entitled to, you might receive a higher paycheck, but could end up owing taxes and/or have to pay penalties.

If you don’t have enough tax withheld, or if you receive a payment that has no withholding at all, such as a check from an investment, then you may want to pay estimated taxes instead. That way, you can meet your tax liability throughout the year, rather than owe penalties and be hit with unexpected bills during tax-filing season.

What a Tax Withholding Means for Individuals

Understanding tax withholding is important for individuals when it comes to tax management and budgeting. If you don’t fill out your W-4 form accurately, for example, you might receive a higher paycheck and spend more money, only to be confronted by a tax bill later on that you’ll have to figure out a way to pay.

Some individuals might consider intentionally having more withheld from their paycheck so they end up with a tax refund after they file. However, you may want to consider other saving strategies, such as depositing a small amount from each paycheck into an interest-bearing bank account.

Key Takeaways

  • Tax withholding is the amount that gets held back from a paycheck or other type of payment for tax purposes.
  • The amount of tax withheld doesn’t always line up exactly with the amount of tax owed, but it often generally covers the approximate tax liability.
  • When filing taxes, if it turns out too much money was withheld, you would receive a tax refund; if too little was withheld, you would owe taxes and potentially need to pay a penalty as well.

Article Sources

  1. IRS. “Employee’s Withholding Certificate.” Accessed Jan. 27, 2022.

  2. IRS. “Tax Withholding.” Accessed Jan. 27, 2022.