Prior to 1943, employees received their entire paycheck without having any money withheld for income taxes. Nowadays, a seeming litany of deductions are taken before you get whatever's left over on payday, because of withholding -- money that the payer takes out and ships directly to Uncle Sam, as well as your state and local tax authority, to offset what you owe at the end of the year.
The federal government requires that you pay taxes on your income as you earn it, rather than waiting until the end of the year and making a lump-sum payment at tax time. Taxes are withheld on your salary and wages as well as pensions, commissions, bonuses and even some gambling winnings. Instead of being paid to you, the money goes to the Internal Revenue Service with your name on it, so you get credit for it when you file your income tax return. At the end of the year, your employer reports the amounts withheld on your W-2.
The amount withheld from your paychecks depends on the Form W-4 that you submitted to your employer when you started work or, if you've updated it since then, your most recent form. On it, you tell your employer whether to withhold at the single or married rate and how many allowances you want to claim. Each allowance reduces the amount of your wages subject to tax withholding. You can claim allowances for things like dependents, having only one job or paying childcare expenses.
Relation to Taxes Owed
In theory, your withholding should roughly equal your federal income taxes due at the end of the year. However, it's not an exact science. When you file your tax return, you first figure how much you owe in taxes and then subtract from that how much you've had withheld during the year. If the result is a positive number, you have to pay extra with your return. If it's negative, you're getting a refund. For example, say your tax liability is $5,000 but you've had $6,100 withheld during the year. Because $5,000 minus $6,100 is negative $1,100, you're getting a $1,100 refund.
Penalties for Underwithholding
Don't think that claiming lots of allowances will let you keep your money longer. Even if you can pay off your tax bill when you file your return, you could owe extra in interest and penalties if you don't have enough withheld during the year. If your tax liability is at least $1,000, you must have had at least 90 percent of of your taxes withheld to avoid interest and penalties. Most people can also avoid penalties as long as your withholding is at least 100 percent of what you owed the last year. However, that amount increases to 110 percent for most filers if your AGI is greater than $150,000. In addition, according to Bankrate.com, you can face both civil and criminal penalties if you claim allowances you knew you weren't entitled to, if that results in underwithholding.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."