Tax withholding refers to the portion of an employee's wages that are retained by an employer for remittance to the Internal Revenue Service (IRS). Two main types of taxes are typically withheld—regular income taxes and Federal Insurance Contribution Act (FICA) taxes, which include contributions to federal Social Security and Medicare programs—although most states and some cities apply their own taxes as well.
Employers are required to withhold 7.65 percent of the first $62,700 of an employee's income for FICA taxes. Employers are also required to match that amount for every employee, so that the total FICA contribution is 15.3 percent. Self-employed persons are required to pay both the employer and employee portions of the FICA tax. The amount of regular income tax that must be withheld from an employee's paycheck depends on the individual's tax status. Ideally, the total income tax withheld should come close to equaling the employee's overall tax liability at the end of the year. Employees can adjust their income tax withholding by filing Form W-4 with their employer and designating the number of withholding allowances they wish to claim.
Tax withholding can affect entrepreneurs and small business owners in two ways. First, small business owners who have employees other than themselves and their partners must withhold payroll taxes for those employees. Second, entrepreneurs who are employees of a company and also have income from self-employment must designate the amount of wages that are withheld from their paychecks.
Withholding is usually done in standard amounts based on formulas provided by the IRS. Employees designate the number of withholding allowances they wish to claim based on their expected tax liability, which depends on their filing status, family circumstances, other sources of income, and available deductions or tax credits. It is not advisable to overpay taxes—even though the extra amount is eventually refunded to the taxpayer—because it is like giving the government an interest-free loan. At the same time, it is not advisable to underpay taxes because it may be difficult to come up with a lump-sum payment when it is due on April 15. In addition, a taxpayer who underpays his or her income taxes by more than 10 percent may face a penalty and have to pay the government interest on the funds owed.
Unfortunately, the IRS guidelines for withholding can cause problems with overpayment or underpayment of taxes even in simple cases, as Michael M. Watts and James E. Gauntt explained in an article for National Public Accountant. For example, a single taxpayer with no dependents and only one source of income would be instructed to claim two withholding allowances to best approximate the total tax owed. But Watts and Gauntt found that this strategy would cause the taxpayer in question to owe between $180 and $190 on April 15. Similarly, a married couple with one income would be instructed to claim three withholding allowances, but this would cause a balance due for the year of $370. The situation was even worse for married couples who both work outside the home.
In addition, many people supplement their regular employment income with interest, dividends, capital gains, rental property, or self-employment income. In many cases, this means that regular withholding from employment income—based on the IRS formulas—is not enough to cover the taxes owed. Instead, these taxpayers should try to estimate their total tax liability and adjust their withholding accordingly. "Wage earners should monitor their expected tax liability versus withholding throughout the year and make adjustments as needed," David S. DeJong and Ann Gray Jakabcin wrote in J. K. Lasser's Year Round Tax Strategies.
Taxpayers are required to pay at least 90 percent of their total tax liability in installments prior to April 15, or they may be subject to a penalty. However, the penalty is waived for taxpayers who pay at least as much in total taxes as they had owed the previous year, or for whom the amount underpaid is less than $500. Since the IRS calculates the amount owed quarterly, a large lump-sum payment in the fourth quarter will not enable a taxpayer to escape penalties. On the other hand, a significant increase in withholding in the fourth quarter may help, because tax that is withheld by an employer is considered to be paid evenly throughout the year no matter when it was withheld. For this reason, taxpayers who see a significant underpayment problem looming should have additional taxes withheld by their employers. "Many people don't realize that they may have as much withheld from their pay as they want, up to the full amount of their salary," according to DeJong and Jakabcin. To avoid a penalty, the total tax withheld must reach 90 percent of what will be owed in the current year or 100 percent of what was owed in the previous year.
This strategy can also work for a self-employed person who falls behind in his or her estimated tax payments. By having an employed spouse increase his or her withholding, the self-employed person can make up for the deficiency and avoid a penalty. The IRS has also been known to waive underpayment penalties for people in special circumstances. For example, they might waive the penalty for newly self-employed taxpayers who underpay their income taxes because they are making estimated tax payments for the first time.
Dailey, Frederick W. Tax Savvy for Small Business. 2nd ed. Berkeley, CA: Nolo Press, 1997.
DeJong, David S., and Ann Gray Jakabcin. J. K. Lasser's Year-Round Tax Strategies. New York: Macmillan, 1997.
The Entrepreneur Magazine Small Business Advisor. New York: Wiley, 1995.
Grassi, Carl. "Federal Withholding Rules Enforced with an Iron Fist." Crain's Cleveland Business. June 12, 2000.
Halphen, Christine. "Revised Withholding Regulations—A Race to the Finish?" Tax Notes. July 10, 2000.
Watts, Michael M., and James E. Gauntt. "Beware the Withholding Tax Trap." National Public Accountant. September 1994.
"When and How to Change Withholding on Wages." Taxes: The Tax Magazine. May 1996.
Wiener, Leonard. "Squaring Your Account with the IRS." U.S. News and World Report. August 29, 1988.
SEE ALSO: Payroll Taxes