If you’ve ever looked at your paycheck and wondered where all your hard-earned money went, you’re not alone. Maybe you’ve even seen a line (with a large number next to it) and wondered, What is withholding tax? And why do they take so much?
Federal and state withholding taxes aren’t a punishment for your hard work.
The tax has a purpose, and in the long run, you’ll probably be glad it was taken from your check rather than on Tax Day.
What is Income Tax Withholding?
You know that you usually must file a tax return by mid-April, but what you might not be aware of is that you actually pay your taxes throughout the year. That’s the state and/or federal withholding you see on your paycheck.
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.
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, you will receive a tax refund when you file your taxes. If you set aside too little, you will owe a balance at that time.
Your federal withholding tax rate depends on your income and tax bracket.
What About State Taxes?
If you live in a state that charges state income tax, you will also see tax withholding for that on your paycheck. There are just nine states that don’t tax earned income:
• New Hampshire
• South Dakota
The concept of tax withholding works the same at the state level as 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’s the Purpose of Federal Withholding?
Imagine getting a tax bill in April for $10,000! Most people couldn’t afford to pay that large sum all at once, so the IRS spread 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 health care programs, education, infrastructure, and other things that keep the country moving forward.
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.
Finding the Right Balance of Federal 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!
If you better balanced what is taken out of your paychecks, you could take the excess you would have paid and invest it.
The IRS has a Tax Withholding Estimator you can use based on your current situation.
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.
Sometimes 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
Attempting to Reduce Your Taxable Income
While there’s no magic wand for paying less in taxes, there are a few strategies that may reduce your taxable income, which could in turn lower federal withholding (as long as you update your W-4).
Investing in Your Retirement
Saving for your future has two big benefits: First, you build a nest egg intended to protect you when you retire. And second, it may help you pay less in taxes now.
Certain retirement accounts, including some individual retirement accounts and 401(k) plans, can reduce taxable income. Say you make $50,000 in salary a year. You put $5,000 into your qualifying retirement account. You will only be taxed on $45,000 because your retirement investment reduces your taxable income.
Investing in Your Health
By contributing to a qualifying health savings account or flexible spending account, you can set aside money for health-related expenses and lower your taxable income.
Contributions to an HSA or FSA (up to the limits set by the IRS) will be deducted from your income when taxes are calculated, likely resulting in your paying less in taxes.
Whether you choose one of these strategies or both, know what you’re getting into. Both retirement accounts and HSAs have limits for how much you can contribute in a year. That amount is higher for couples or families.
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.
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