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What Is Income Tax Withholding and How Does It Work?

By Susan Guillory · January 20, 2023 · 8 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is Income Tax Withholding and How Does It Work?

“What happened?!” may be your response when you look at your paycheck and see all of those deductions, whittling your hard-earned cash down to a (much) lower figure than you expected.

And perhaps, if you look more closely, you’ll notice a line on your paystub that shows a major amount of money subtracted and think, What is withholding tax? And why do they take so much?

Federal and state withholding taxes are funds that your employer takes out and sends to the government. To put it another way, this is what “taxes withheld” means; the funds have gone to help federal programs. These taxes have a purpose, and in the long run, you’ll probably be glad they are deducted from your check rather than owed as a mega lump sum on Tax Day.

But that said, it can be wise to learn more about what income tax withholding is and what those funds do. Read on learn answers to such questions as:

•   What is tax withholding?

•   What are factors that determine withholding taxes?

•   How can you calculate withholding taxes?

What is Income Tax Withholding?

Many people think their taxes are due mid-April, but did you realize that, if you are a salaried employee, you are actually paying your taxes throughout the year? When you see those federal and possibly state and local taxes being whisked out of each paycheck, that’s exactly what is happening.

So what does withholding tax mean, and how does it work? A withholding tax is an amount, based on your salary, that your employer sets aside and then pays directly to the government on your behalf. It’s a credit against the full amount of personal income tax you will owe for the year. By doing this, your employer is helping you avoid paying all of your annual taxes come April.

That said, how much is deducted from your paycheck can vary depending on a variety of factors. You are able to designate what portion of your check goes toward your taxes on the IRS W-4 form (more on that in a bit).

•   If you allocate too much, that means more than necessary is taken out, and you will likely receive a tax refund when you file your taxes.

•   If you set aside too little, you will probably owe a balance or have what’s known as a “tax bill” due during tax season to make up the difference.

Your federal withholding tax rate depends on your income and tax bracket.

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Factors That Determine Tax Withholding

There are several factors that determine just how much tax is withheld from your paycheck, whether it arrives as a paper check or via direct deposit. Here are some of the factors that control the amount:

•   How much you earn; it’s likely that the more you earn, the higher the rate at which taxes are withheld

•   What your filing status is (for instance, single; married, filing singly; or married, filing jointly)

•   How many (if any) withholding allowances are claimed. Typically, if you claim a higher number of allowances, that means your tax deductions are lower. This will free up more cash to flow your way on each payday, but you might owe taxes when you file. If you have a lower number of allowances, that means more money is taken out for taxes, and you could wind up getting a refund when your tax return is processed.

•   Whether an employee decides to have additional money withheld each pay period so they won’t owe takes in April. Some individuals may ask their employers to withhold, say, an extra $100 or more per pay period if they find they typically owe taxes at year’s end.

Recommended: How to Reduce Your Taxable Income

What Is State Income Tax Withholding?

If you live in a state that charges state income tax, you will also see tax withholding for that on your paycheck. In terms of the different types of taxes collected, there are just nine states that don’t tax earned income. In other words, you will not pay state taxes if you live in:

•   Alaska

•   Florida

•   Nevada

•   New Hampshire

•   South Dakota

•   Tennessee

•   Texas

•   Washington

•   Wyoming.

The concept of tax withholding works in the same way at the state level as it does at the federal: A certain portion is put toward your future state tax bill, and you may either owe or get a refund, depending on how much you paid in.

What Is the Purpose of Tax Withholding?

As briefly mentioned above, tax withholding saves you from owing a huge bundle of taxes in April. If people were left to their own devices to set aside money for taxes, well, that might not always be a success. It can be hard to save money from your salary. Every time you receive your paycheck, there are bills to pay, dinners out and movies to tempt you, and vacations to plan and take.

If you received your gross vs. net income, you might spend more than you mean to and then wind up owing a large sum to the IRS when tax-filing takes place. This is one reason why the IRS spreads out the federal income tax withheld across paychecks throughout the year.

You don’t see the taxes you pay as such a large sum when bits are taken throughout the year, and you likely don’t miss that money the way you would if you paid all at once.

And the government probably prefers to receive revenue from federal withholding throughout the year rather than all at once. This money is put toward healthcare programs, education, infrastructure, and other things that keep the country moving forward.

Recommended: Your Guide to Filing Taxes for the First Time

Tax and Employment Documents to Know

When you are first hired at a company, you fill out a W-4 form that includes your salary and tax withholding. Whether you are single or married and whether you have dependents or other withholding allowances will determine how much of each paycheck is diverted toward your federal tax bill. You may also opt to have additional funds withheld from each paycheck.

Then when tax time rolls around, you will receive IRS Form W-2. This includes information on how much income you earned in a given tax year, as well as how much you paid in federal, state, and other taxes.

You’ll use this W-2 to file your taxes, and it will determine whether you receive a tax refund, owe more taxes, or break even.

Calculating Income Tax Withholding

It can take a bit of tweaking to find that balance between overpaying in federal withholding and having to pay more when you file your taxes.

Some people like getting a tax refund because it’s a lump sum they can put toward debt or invest. But realize that overpaying is a bit like giving the government a free loan throughout the year!

While there may be fast ways to get a tax refund, perhaps you’d rather just hold onto that money in the first place. If you better balanced what is taken out of your paychecks, you could take the excess you would have paid and invest it.

If you’re wondering what is a withholding tax allowance that’s right for you, there’s help. The IRS has a Tax Withholding Estimator you can use based on your current situation. In general, the more allowances or exemptions you have, the less taxes that will be taken out of your pay. And the opposite is true: The fewer the exemptions, the higher the amount of taxes that will be withheld.

While you aren’t asked to fill out a new W-4 each year, you may request one if you think you need to adjust the withholding amount.

Some of the times it might be wise to adjust how much income tax is withheld include:

•   Starting a new job or position

•   Having a child

•   Getting married or divorced

•   Buying a house.

Can I Be Exempt from Tax Withholding?

To be exempt from tax withholding means that no federal taxes will be withheld from your pay. You might also have no state or local taxes (if applicable) deducted. Here are the ways in which someone might qualify to be exempt from such taxes:

•   If all of your federal income tax was refunded because you have no tax liability and you expect the same thing to happen this year, then you may be exempt from withholding taxes. (But note, Social Security and some other taxes may still be withheld as part of other types of payroll deductions.)

•   Another consideration: Certain types of income are considered exempt. For instance, money paid to foster parents for their taking care of children in their homes may be tax-free. Payments from workers’ compensation is another example of funds that may be tax-exempt.

The Takeaway

No one likes the idea of taxes, but the fact is that money is put toward things we all enjoy, like smooth roads and education programs. And federal withholding from your paycheck keeps you from having a giant bill when you file taxes.

The important thing is to understand how much is being withheld and knowing whether you need to modify your W-4 to find a better balance between overpaying and owing more money in taxes.

3 Money Tips

1.    Direct deposit is the fastest way to get an IRS tax refund. More than 9 out of 10 refunds are issued in less than 21 days using this free service, plus you can track the payment and even split the funds into different bank accounts.

2.    If you’re creating a budget, try the 50/30/20 budget rule. Allocate 50% of your after-tax income to the “needs” of life, like living expenses and debt. Spend 30% on wants, and then save the remaining 20% towards saving for your long-term goals.

3.    If you’re faced with debt and wondering which kind to pay off first, it can be smart to prioritize high-interest debt first. For many people, this means their credit card debt; rates have recently been climbing into the double-digit range, so try to eliminate that ASAP.

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FAQ

Does the government pay for income tax withholdings?

Money that is withheld from your earnings, known as income tax withholding, goes to the government. These dollars help pay for federal programs that benefit citizens and keep our country running, from education to transportation to economic security expenses.

How can someone qualify for withholding exemption?

To qualify as tax-exempt, you would have to have had all taxes refunded and have no liability in the previous year and expect the same status in the current tax year. Another consideration: Some forms of income may be tax-exempt, such as payments for in-home foster care of children or for workers’ compensation.

Why has my employer withheld too much income tax?

If your employer withheld too much income tax, then you will likely get a refund at tax time. You can update your withholding on your W-4 form; the more allowances you have, the lower the taxes that will be taken out.

Why has my employer withheld too little income tax?

If you wound up owing the IRS money at tax time, the issue could be that you have too many exemptions or allowances claimed on your W-4 form, meaning your employer is not withholding enough money from your paycheck. Adjust your W-4, knowing that the lower your number of allowances, the higher the level of taxes that will be taken out and sent to the IRS on your behalf.


Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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