Withholding Judgement

While at lunch with a group of coworkers recently, a colleague made a comment about how unfair it is that bonuses and overtime gets taxed at 40%. He had recently received a paycheck for $50 with $20 worth of tax taken out, and wanted to know why the government is taxing this type of income so heavily.

The answer, I was surprised to learn, is that they weren't taxing him at 40% after all. The misunderstanding arose from the governmental policy of tax withholding, a process with is sufficiently nebulous that most people have no idea how it works (or even why it occurs). This article will attempt to clarify the concept of withholding while also exploring how to insure that an appropriate amount of income is withheld.

A bit of history

First, it's important to cover some history of taxation in the United States. Taxation has been a part of American life since pre-revolutionary times, and was deemed important enough that the Congress is specifically empowered by the Constitution "to lay and collect Taxes, Duties, Imposts, and Excises...". With the development of the modern income tax during the Civil War, the government faced the dual challenges of determining how much taxable income was earned, and also insuring that owed taxes were actually paid. (For more information about the history of taxation in the United States, you might enjoy reading the Department of the Treasury's History of the U.S. Tax System.)

In modern times, this responsibility is largely delegated to the individual employer. First, employers are required to report earned income to the government and to the employee using Form W-2. Secondly, employers are required to withhold a certain amount of income from each paycheck and pay it to the government, which will then count it towards taxes owed at the end of the year. This process has greatly simplified the process of collecting taxes, but also made it more difficult for employees to realize how much tax was actually being paid on a month-by-month basis.

This difficulty is what lead to my colleague's misunderstanding. Although it appeared that his paycheck was being taxed at 40%, it was actually being withheld at 40%. What's the difference? With withholding, you can (often) get the money back.

How Withholding Works

Four things are routinely withheld from an ordinary paycheck: Social Security, Medicare, Federal Income Tax, and State Income Tax. Social Security and Medicare are withheld at 6.2% and 1.45% respectively, while the amount of Federal and State income taxes withheld will vary based on your expected filing situation and the number of allowances you take.

The most important thing to remember about allowances is that they are not the same as deductions. Deductions are used to reduce the amount of tax you have to pay at the end of the year. Allowances simply control how much tax is withheld from your paycheck in advance.

By default, tax is withheld from your paycheck at a certain fixed rate based on your projected annual income level. (Jonathan previously discussed these rates in his post, Owing the Government less money by maximizing deductions! (Part 1)). However, since nearly everyone gets some type of deduction or income adjustment, this would result in everyone having too much income withheld. To compensate for this, you can use your previous tax return to predict how much tax you will owe in the following year. You can then take a certain number of allowances to reduce the amount of money which is withheld from your paycheck. This will reduce the size of your end-of-year refund, but will increase the amount of money you see in your paycheck every month.

So how do you calculate how many allowances to take? The easiest way is to use the IRS Withholding Calculator. Once you've completed this, you can file an amended Form W-4 with your employer as described in IRS Publication 919. To see how a change in allowances will affect your take home pay, refer to IRS Publication 15, section 16. It's also worth noting that according to IRS Topic 753, you may be subject to a $500 fine if you submit (without reasonable basis) a W-4 which results in less tax being withheld than is required.

Supplimental Wages

You may be asking yourself, "Okay, I understand that your friend wasn't getting taxed at 40%...but why was he getting withheld at 40% if he had already reported correct allowances on his W-4?"

According to IRS publication 15, section 7, overtime and bonuses can be handled one of several ways:

1. The employer can pay supplimental wages on the same paycheck as normal wages, and withhold at the the standard rate.


2. The employer can pay supplimental wages on a separate paycheck, but calculate the withholding as though the wages were paid in one lump sum.


3. The employer can withhold at a flat rate of 25%.

For convenience, many employers will simply go with the third option. The result of this is that more tax is withheld from each check than is actually necessary. When combined with Social Security (6.2%), Medicare (1.45%), and state withholding (6% for Georgia), this adds up to nearly 40% of your income being withheld. If you work a lot of overtime or typically receive a large bonus during the year, it may be worth using the IRS Withholding Calculator to adjust your allowances on ordinary income to compensate for this, so that you don't have to wait up to 15 months to get a refund on that additional withheld income.

State Taxes

State income taxes are also typically withheld from your paycheck alongside Federal Taxes, but (with the exception of a handful of states), the withholding calculations are completely different. For taxes collected in Georgia during 2008, allowances are calculated by taking the deductions listed on Georgia Form 500 and amortizing them over the number of paychecks which will be issued during the year.

Summary

Withholding is an important component of the modern tax system to be aware of. Even if you are able to take a tremendous number of deductions on your annual tax return, you'll still only see this money once per year (in the form of your tax refund) unless your withholding allowances are set correctly. Correct withholding also makes it easier to avoid making a large unexpected tax payment every April. Finally, it keeps you more aware of what is actually going on with your earnings, and makes it possible to more accurately budget and plan for upcoming expenses.

If anyone has questions about anything discussed here, please let me know, and I will discuss them in a followup article.