Tax withholding

Withholding is an estimate of the tax, paid in advance, and not the tax itself. Each payday the employer takes the pay for the period, the choices on your Form W-4 and the government's withholding tables, and sends the resulting amount in along with the Social Security and Medicare taxes. The year's withholding is credited against the tax the return computes, so a $2,400 refund means $200 a month was withheld beyond what was owed, and a bill in April means too little was. The W-4 is the dial, and it can be turned on any payday.

In a sentence

• "Federal tax withholding on my paycheck is $611 a month, and the return showed the year's tax came to $2,400 less than that adds up to."
• "Tax withholding is a prepayment; the return in spring is where the real figure is worked out."
• "She filed a new W-4 to lower her tax withholding, and her take-home pay went up $200 a month."

How it works

1. You give your employer a Form W-4 when you start, and a new one whenever you want the amount changed. It records your filing status, whether there is a second job or a working spouse, dependents, other income, the deductions you expect to claim, and any extra dollar amount to withhold from each paycheck.
2. Each pay period the employer finds the taxable wages: gross pay minus the pre-tax deductions, such as a traditional 401(k) contribution and the health premium.
3. The employer applies the withholding tables the IRS publishes for that pay frequency to those wages, using the W-4's entries, and withholds the result. A state with an income tax has its own form and tables, and some cities add a local tax.
4. Social Security and Medicare are withheld separately, at flat rates of 6.2% and 1.45%, whatever the W-4 says. They are payroll taxes rather than income tax, and for most employees they are exactly what is owed.
5. The employer deposits the money with the IRS and the state through the year and reports the totals on your W-2 in January.
6. The return settles it. The year's tax is computed from all income, deductions and credits, the withholding is subtracted, and the difference is a refund or a balance due. Paying too little through the year can also carry an underpayment penalty.

An example

A $74,400 salary with $611 of federal income tax withheld from each month of pay. The example assumes the return computes the year's tax at $4,932.

The tax was the same in both years. What changed was when it was paid: in year one the household lent the government $200 a month and got it back the following spring, and in year two the $200 stayed in each paycheck, so take-home pay rose from $4,400 to $4,600 a month with no raise. The refund did not disappear; it was paid out twelve times, in the months the bills were due.

Why it matters

Withholding sets take-home pay directly, and it is the one paycheck deduction you control from month to month. Set high, it produces a refund, a year of interest-free lending that some households keep on purpose as a savings plan they cannot touch. Set low, it produces a bill, and possibly a penalty, on money that was spent months ago. The common way it goes wrong is two incomes: each employer withholds as if its paycheck were the only one, so two jobs or two earners come up short unless the W-4's multiple-jobs section is used, and a side income with nothing withheld does the same. A marriage, a child or a large change in pay is a reason to redo the form rather than wait for April to report the difference.

Tax withholding versus estimated tax payments

Withholding is how employees prepay income tax, through an employer who takes it from wages; estimated tax payments are how everyone else does it. A freelancer, a contractor or a landlord has no employer to withhold, so they set aside a share of each payment and send it to the IRS themselves, four times a year. Both prepay the same tax and both are credited on the same return. A person with a job and a side income can cover the side income's tax by raising the withholding at the job instead of making estimated payments; a freelancer with no job runs on the set-aside, commonly 25% to 30% of each payment at first. See How to pay yourself a salary from freelance income and How to budget with a side income or a second job.

Common questions

Is tax withholding the same as the tax I owe? No. Withholding is an estimate paid through the year; the tax is computed on the return from all of the year's income, deductions and credits. The refund or the bill is the difference between the two.

How do I change my withholding? Give your employer a new Form W-4. The IRS publishes an online estimator that fills in the entries from last year's return and this year's pay, and the change shows on the next paycheck or two, so check that the new amount is what you expected.

Is a big refund a good thing? It is a sign that too much was withheld, which means the household lent the money interest-free for a year. It is a good thing only if the household would not have saved the $200 a month otherwise, and knows that is the trade it is making.

Why was too little withheld? Two jobs or two earners, each withheld on as if it were the only income; a side income with nothing withheld; a bonus, which employers often withhold on at a flat rate that may not match yours; or a change in dependents or filing status that never reached the form.

Are Social Security and Medicare part of tax withholding? They are withheld from the paycheck at flat rates of 6.2% and 1.45%, but they are separate from income tax withholding, are not set by the W-4, and do not usually produce a refund or a bill.

Go deeper

• What to do with a tax refund, and how to budget it treats the refund as withholding returned and shows what adjusting the W-4 turns it into, $200 a month in the worked example.
• How to pay yourself a salary from freelance income sets aside the tax share from every client payment, since no employer withholds for a freelancer, and pays the quarterly estimates from it.
• The Budget calculator splits monthly take-home pay, the figure left after withholding, into needs, wants and savings with the 50/30/20 rule or shares of your own.