A Summary of the US Payroll Income Tax Withholding System
By David F. Jarmusz |
You moved to the US and have a great job with a company that withholds Federal and State income taxes from your paychecks. Everything is going great until April 15 arrives, the due date of your annual tax filing, when you discover you owe even more income tax to the IRS! But you’ve been paying taxes all year, why do you now owe more? In some cases, you may even be charged a penalty for the underpayment of income taxes…what’s going on?? For those of you from countries that have withholding rules similar to the UK’s Pay as You Earn (PAYE) system, all the taxes you need to pay are withheld from your paychecks. This is NOT the case in the US.
Similar to many countries, the US Internal Revenue Service does not want taxpayers paying all that is owed on the due date of their annual tax filing. Rather, the IRS wants you to pay the tax when the income is earned and in most cases with employees, additional taxes would be paid evenly throughout the year, likely in the form of estimated quarterly payments made directly to the IRS. What is different in the US is that the income tax withheld from your paychecks is NOT meant to cover your entire tax liability for the year. As a result, an additional payment may be necessary when your annual return is filed.
So what is required to be withheld from your paycheck? First, it varies by state. In addition, it is the job of your company’s payroll department to follow their own Federal and State withholding tax rules.
Penalties Not Welcome
Keep in mind that for most taxpayers, these rules are not meant to cover your entire tax liability, only a portion of what is due. In fact, it is not uncommon for higher income tax payers to be subject to a penalty for not withholding enough tax even though the correct tables were used by the payroll department. Why? Here are the most common reasons:
- You have income from other sources where income tax is not withheld, such as gains on stocks or other investment income
- You are married with income greater than $250,000 (single $200,000) and are subject to the 3.8% net investment income tax
In both of these cases, enough income tax may not be withheld to prevent an underpayment penalty.
No Surprises: You’re In Control
When it comes to paying taxes, our clients fall into two categories. The first prefer to pay the bare minimum so as not to loan “Uncle Sam” free money. This tact can result in a large amount due on April 15. No one wants to receive an unexpected tax bill! The second group does not want to have a large payment due and contributes more from each paycheck toward taxes. How do you control how much is withheld? When you started with your company you likely signed a novel’s worth of forms including a W-4, “Employee’s Withholding Allowance Certificate”. This form tells your payroll department how much income tax you would like withheld from your paychecks and can be filed with your payroll department multiple times (be kind to them, not too many times!) throughout the year. This is your main tool to control how much tax you pay during the year so you can avoid those surprises!