The government wants your money sooner rather than later. Thus, it imposes withholding requirements for many payers of compensation, investment income, and winnings, such as salary and wage income, tips, pensions, and some retirement distributions. Withholding on gambling winnings is subject to special rules. Taxes are also withheld on interest and dividends if the payer does not have the taxpayer's identification number, which, for most people, is their social security number. Both federal income and Federal Insurance Contributions Act (FICA) taxes, which includes Social Security and Medicare taxes, must be withheld.
Both wages and benefits are subject to withholding, except for tax-free fringe benefits, such as health insurance coverage. For supplemental wages, which is irregular income, such as commissions and bonuses, an employer can choose to withhold a flat 25% instead of using tax tables to determine the withholding. The employer must generally withhold on taxable fringe benefits, but the employer has some leeway in choosing when the benefits are considered paid, which can be every payroll period, quarterly, but it must be at least once a year. If the employer notifies the employee, then the employer can choose not to withhold tax on the personal use of employer-provided motor vehicles, such as cars and trucks. Additionally, any benefit paid in November or December can be considered to be paid in the following year, as long as the employer notifies the employee of this rule. The employer can figure the withholding amount by either adding it to pay, then calculating the withholding tax or by withholding a flat 20% of the benefit's value. If the actual value of the benefit cannot be determined, then it must be reasonably estimated. However, the employer must determine the actual value by January 31 of the next year. If the actual value was greater than the estimate, then the employer must pay the additional withholding tax, but can recover that amount from the employee, up until April 1.
Withholding is also required on sick pay, retroactive and over-time pay, taxable supplemental unemployment compensation benefits, taxable group insurance coverage over $50,000, reimbursements of expenses that are not from an accountable plan, which must satisfy specific tax rules, or if reimbursements exceed federal rates unless the excess reimbursement is returned or substantiated by proof of expenses.
A backup withholding rate of 28% must be applied to payments of interest, dividend, or royalty income and for payments of at least $600 to independent contractors, payments from brokers, and some gambling winnings if the taxpayer fails to provide a taxpayer identification number or Social Security number to the payers. Providing false information to avoid backup withholding can result in a civil penalty of $500 or a criminal penalty of $1000 or 1 year imprisonment or both.
Generally, employers calculate the amount to withhold by projecting the periodic wages paid to an employee over the entire year. This amount is modified by the number of withholding allowances that the employee is permitted to claim by submitting Form W-4, Employee's Withholding Allowance Certificate. The employee can figure the number of withholding allowances to claim by a using the worksheet on Form W-4. If an employee does not submit a Form W-4, then the employer must withhold at the highest rate, which is that of a single person claiming no withholding allowances.
An employee working only part of the year may request that withholding be based on the expected time that the employee will actually work for the employer. The employee can ask the employer to use the part-year method if the total workdays for the year is not expected to exceed 245. The cumulative wage method can also be used if the payroll period for the entire calendar year is expected to be the same (i.e., weekly, biweekly, and so on). Both the part-year method and the cumulative wage method must be requested by the employee in writing.
Nonperiodic retirement distributions are subject to a 10% withholding rate unless the taxpayer chooses otherwise. Employers must withhold 20% of retirement distributions that are eligible for a rollover but are, instead, paid directly to the taxpayer. The request to avoid withholding on retirement distributions is made on Form W-4P, Withholding Certificate for Pension or Annuity Payments. However, withholding cannot generally be avoided if the payments are to a US citizen or resident alien outside of the US or its possessions.
Special rules apply to employees who receive cash tips, because this type of compensation is frequently not reported. If an employee receives cash tips, and the total amount exceeds $20, then the employee must report the tips on Form 4070, Employee's Report of Tips to Employer to the employer. Only the tips that the taxpayer gets to keep are reportable. Service charges that are included as part of the price or are paid by credit card that are paid by the employer to the employee are not reported by the employee.
Tips must be reported monthly by the 10th day after the end of the month or the 1st business day after that, if the 10th day falls on a weekend or holiday. However, the employer may require tip reporting more frequently than monthly. Tips for less than $20 per month are taxable, but are not required to be reported to the employer.
The penalty for failing to report tips is 50% of the Social Security and Medicare tax due on the unreported tips unless there was a reasonable cause rather than willful neglect to report the tips. Tips that are required to be reported but are not, or tips that are allocated under a special tip allocation rule must be reported on Form 4137, Social Security and Medicare Tax on Unreported Tip Income, which the taxpayer uses to calculate the Social Security and Medicare taxes on the unreported income.
Restaurants employing at least 10 people must allocate a percent of gross receipts to tips, so that if any employee reports less than 8%, then the employer will allocate the difference, which is not subject to withholding but will be reported to the IRS. If justified, either an employer or the majority of employees can ask the IRS for a lower percentage but not less than 2%. Allocated tips are reported on Form W-2, Wage and Tax Statement.
Exemptions and Allowances
For employees, the amount that is withheld is determined by the number exemptions and allowances claimed on Form W-4, Employee's Withholding Allowance Certificate, which the employee submits to the employer. The employee can figure the number of permissible exemptions and allowances that can be claimed by using the Deductions and Adjustments Worksheet on page 2 of Form W-4. If no Form W-4 is submitted, then the employer must treat the employee as a single person with no exemptions, resulting in the maximum amount withheld. Generally, 1 exemption can be claimed for the taxpayer and for each dependent. Besides the number of dependents, withholding can be reduced if the taxpayer has deductions and credits that can be claimed that would reduce tax liability. Most common exemptions for dependents include the taxpayer, spouse, and children.
A single taxpayer with only 1 job, or with a 2nd job with earnings not exceeding $1500 per year, can also claim an additional allowance. Likewise for a breadwinning spouse, if no more than $1500 is earned either from a 2nd job or from wages earned by the other spouse. A head of household can also claim an additional withholding allowance.
Married taxpayers filing a joint return should only fill out one set of Form W-4 worksheets, even if both spouses have separate jobs and must turn in a Form W-4 to each employer. Withholding allowances should be split between the 2 Form W-4's. Except for residents of Canada or Mexico, taxpayers who are neither citizens nor residents of the United States may usually only claim 1 withholding allowance, unless the spouse is a US citizen or resident and has chosen to be treated as a resident of the United States for tax purposes, or the taxpayer is a US national.
Additional allowances can be claimed for itemized deductions and such tax credits as the child tax credit and the child and dependent care credit. For instance, if you pay a mortgage, then you can easily estimate your deduction for mortgage interest paid during the year and for real estate taxes on the property, so if you expect that these itemized deductions will total $14,000, then you can use that amount in calculating your permissible allowances on Form W-4.
Supplemental wages, which includes bonuses, commissions, overtime pay, vacation and sick pay, and expense allowances, may also change the number of allowances that can be claimed on Form W-4. If the employer includes supplemental wages in regular wages, then the employer can determine withholding based on the total wages. If supplemental wages are listed separately, then the employer can withhold taxes at a flat rate.
Expense reimbursements can be paid from either an accountable plan or a nonaccountable plan. Expense reimbursements paid from an accountable plan are not taxable, so they are not included as supplemental wages. To be treated as reimbursements from an accountable plan, expenses must have a business connection, must be reported to the employer within a reasonable time, and the employee must pay any excess reimbursement within a reasonable time. Any excess reimbursement will be treated as supplemental wages. Reimbursements from nonaccountable plans are treated as supplemental wages.
An employee can request an exemption from withholding of federal tax, but not Social Security or Medicare tax, on Form W-4, if the employee either had no tax liability for the previous year or expects to have no tax liability for the current year. This commonly occurs when the employee does not expect to earn more than the standard deduction + personal exemption, which, in 2015, was $10,300. If income is more than this, then the exemption may still be claimed if itemized deductions and tax credits plus additional exemptions for dependents reduces tax liability to 0. If the employee can be claimed as a dependent by another taxpayer, then he can only claim the standard deduction, which in 2015, was $6300. Therefore, the employee can only claim the exemption if his income is not expected to exceed the standard deduction amount and his unearned income is not expected to exceed $350. Unearned income is income from investments, such as interest or dividends. The exemption from withholding must be claimed every year. If changes in the employee's situation will incur some tax liability for the year, then a new Form W-4 must be filed within 10 days of the change or from when the employee realizes that there will be some tax liability. If the employee expects to owe income tax for the next tax year, then a new Form W-4 must be filed by December 1 of the current year.
Fewer withholding allowances should be claimed if you have investment or self-employment income, either by claiming fewer exemptions, or by withholding an additional set amount from each paycheck. Changes can be made at any time by submitting a new Form W-4 to the employer.
Personal allowances are reduced if adjusted gross income (AGI) exceeds the personal exemption phaseout threshold:
|Filing status||Threshold |
|Head of Household||$293,350||$415,850||$287,650||$410,150|
|Married Filing Jointly||$320,000||$442,500||$313,800||$436,300|
|Married Filing Separately||$160,000||$282,500||$156,900||$279,400|
|Filing status||Threshold |
|Head of Household||$285,350||$284,050||$279,650||$275,000|
|Married Filing Jointly||$311,300||$309,900||$305,050||$300,000|
|Married Filing Separately||$155,650||$154,950||$152,525||$150,000|
If your AGI is above the phaseout threshold, then itemized deductions will also be reduced, which can be figured on the Form W-4 worksheet.
The Form W-4 worksheet does not account for the following situations:
- both spouses work
- you have
- more than 1 job
- investment income
- self-employment income
- earnings exceeding $130,000 ($180,000 if married)
- work only part of the year
- or you are subject to the Additional Medicare Tax or net investment income tax.
Exemptions from Withholding
The self-employed pay estimated taxes, as do others who are not subject to withholding. Withholding is not required in compensating household workers, but the household employer can arrange to have withholding if the employees agree to it. No withholding is required for reimbursements of deductible moving expenses or medical care benefits paid through self-insurance.
Also exempt from withholding are:
- substantiated payments for traveling expenses, payments to nonresident aliens, ministers, agricultural workers, jurors, witnesses, and some others who are specifically exempted from withholding
- payment to a child younger than 18 for newspaper home delivery
- wages that were due at the death of the employee that is paid to the estate or a beneficiary
- death benefit payments.
Part-time workers, such as retired persons or students, can avoid withholding of income taxes, but not Social Security or Medicare taxes.
Reporting or Changing Tax Withholding
A Form W-2, Wage and Tax Statement, which reports the total compensation received and the amount of tax withheld, must be sent by the employer to each employee by the end of January of the following tax year, showing the amount of both payment and withheld tax, and withheld Social Security and Medicare taxes. An employee can request a W-2 form if employment ends during the tax year, in which case, the employee should receive the form within the later of 30 days after either the request or the final wage payment. The employer sends a Form W-2 to both the employees and to the IRS. Withheld tax on other types of income are usually reported on Form 1099-MISC, Miscellaneous Income.
Although employers are not required to submit the W-4 forms to the IRS, the IRS may request those forms for specific employees, who they think may be claiming too many exemptions from withholding. To prevent gross under withholding, the IRS may send a lock-in letter that requires the employer to limit the number of claimed exemptions for the employee. A $500 civil penalty may apply if there is not a reasonable basis for the number of exemptions claimed. If the employee supplies knowingly false information, then a $1000 criminal penalty, or even a possible jail sentence of 1 year, may be assessed, though highly unlikely.
Claimed exemptions or withholding allowances should be changed whenever there is a change in the taxpayer's situation, such as:
- marriage or divorce
- the birth or adoption of a child
- buying a new home
- changes in wages or other taxable forms of compensation
- changes to taxable income not subject to withholding, such as self-employment income, distributions from a traditional IRA account, or interest, dividends, and capital gains
- changes to adjustments to income, such as an IRA deduction, alimony expenses, or the deduction for student loan interest
- changes in itemized deductions, such as increased job expenses, dependent care expenses, medical or dental expenses, charitable gifts, and interest expenses
- changes in certain tax credits, such as the child tax or earned income credit or the education credit
- filing Chapter 11 bankruptcy
If your personal or financial situation changes that would reduce the number of permissible allowances or if your marital status changes from married to single, then you must submit a new Form W-4 to your employer within 10 days. The employer must use the information from any newly submitted Form W-4 by the 30th day after the employee submits the form.
A quick and easy way to determine how much tax should be withheld from your income is to use the new IRS Withholding Calculator. After answering a few questions, it will then present a results page with a summary of all the information that you have entered and how many allowances you should claim on the Form W-4. Note that the anticipated income tax is the marginal tax on income; it does not include employment taxes, which are the responsibility of the employer. The employer can easily calculate employment taxes because they are not affected by deductions, credits or by the number of allowances.
The taxpayer can also request voluntary withholding for social security benefits and for unemployment compensation by filing Form W-4 in lieu of making estimated tax payments. The requested rate for withholding must be 10% for unemployment compensation, but for Social Security and other government payments, 7%, 10%, 15%, or 25% can be chosen.
How To Determine How Much Additional Tax to Withhold?
If you suspect that not enough taxes being withheld from your income, you can determine how much should be withheld by using the worksheets in Publication 505, Tax Withholding and Estimated Tax, then determine how much it would be withheld at the current rate. Subtract that amount from the amount that should be withheld, then divide by the number of paydays left in the year. Enter that amount as an additional withholding amount on Form W-4.
|Projected Tax Liability||$6,000|
|Projected Tax Withholding||$4,200|
|Underwithholding Amount||$1,800||= Projected Tax Liability – Projected Tax Withholding|
|Paydays Remaining for Year||10|
|Additional Amount to Be Withheld for Each Payday||$180||= Underwithheld Amount ÷ Paydays Remaining for the Year|
Social Security and Medicare taxes, collectively referred to as FICA (Federal Insurance Contributions Act) taxes, are subject to flat rates of 6.2% and 1.45% respectively for the employee portion; the employer pays the other half of the FICA taxes. An additional 0.9% Additional Medicare Tax may also be withheld for those with wages exceeding $200,000 in any calendar year. Claimed exemptions and allowances do not affect FICA withholding since they do not affect the tax liability in most cases, although the Additional Child Tax Credit can be used to offset the employee's portion of the FICA tax.
If an employer withholds too much FICA tax, then the employee must request a refund from the employer of the excess amount withheld; if the employer refuses, then the taxpayer can claim a refund on Form 843, Claim for Refund and Request for Abatement. Wages paid to children of business owners who work in a family business are exempt from FICA withholding but only if the business is a sole proprietorship or partnership where only the parents are partners. Wages paid to children younger than 21 or to spouses for domestic work or child care are also exempt from FICA withholding.
Tax Penalties May Apply for the Underpayment of Tax
If, by the end of the tax year, tax liability is significantly greater than what was withheld or paid through estimated tax payments, then an underpayment tax penalty may apply.