Tax Withholding : A Guide for U.S. Employees and Employers

Every time you run payroll, you’re not just paying salaries; you’re also calculating, deducting, and remitting taxes to the government. That’s tax withholding.

Withholding too much can frustrate employees expecting higher take-home pay. Withholding too little can lead to tax bills and penalties that reflect poorly on your company’s processes. Add in changing IRS rules, updated W-4s, and multi-state tax complications, and it can quickly get overwhelming.

That’s why we created this simple, straight-talking guide to help you understand what tax withholding really is, and how it works. We also delve deep into what your responsibilities are and how you can streamline the process to protect your business and support your team.

What Is Tax Withholding?

Tax withholding is the portion of an employee’s wages that an employer deducts and remits directly to the government as a prepayment of the employee’s income tax liability. This system ensures that taxes are collected gradually throughout the year, rather than in a lump sum at year-end.

Each pay period, you send part of your employees’ taxes to the government. At the end of the year, their W-2 shows how much tax has already been paid on their behalf.

If the withholding was paid more than required, employees get a refund, and if it was less, they get a tax bill.

While tax withholding is commonly associated with salaried employees (through payroll withholding), it also applies to freelancers, consultants, and business transactions, especially when services are exchanged between businesses or across borders.

Withholding taxes vs Estimated taxes

Withholding taxes are amounts automatically deducted from an employee’s paycheck by their employer to cover income taxes and FICA obligations. Estimated taxes are manually paid by individuals who don’t have taxes withheld from their income.

These taxpayers are responsible for estimating their income and tax liability, then sending payments to the IRS (and state, if applicable) four times a year, typically in April, June, September, and January. These payments also include self-employment taxes, which cover Social Security and Medicare.

For Salaried W-4 Employees

Each time you pay your employees, you automatically deduct the required amounts for federal income tax, FICA taxes (Social Security and Medicare), and state/local taxes if applicable.

These deductions are based on the details your employees provide in Form W-4, including your filing status, dependents, and any additional withholding.

This system is automated and employer-managed, making tax compliance easier for employees.

For Freelancers and Small Businesses

With respect to consultants and business-related transactions, withheld taxes are a deduction made by a party who is processing the payment to another, as tax paid in advance.

If you’re a business receiving a product or service from a provider, when you make the payment, you deduct a percentage from the vendor payment as a specific withholding tax and remit it to the tax authority in the name of the vendor. That, in turn, becomes a tax credit that your vendor can use against future tax liabilities.

If the vendor resides in a different country, the refundability of the deducted withheld tax would depend on the jurisdiction where the foreign vendor is resident.

The amount you withhold must be:

• Deposited with the tax authority within a specific timeframe
• Reported with details of the vendor, including their tax ID
• You may be required to deduct withholding tax at a specific rate depending on the Double Taxation Avoidance Agreement (DTAA) between your country and the vendor’s country.
• The withheld tax must be remitted to your domestic tax authority.
• The foreign vendor will receive less than the invoice amount, but they can potentially claim a credit or refund in their own country, depending on local laws.
• Supported by issuing a certificate, so the vendor can claim the credit

Types of Withholding Taxes

Payroll tax withholding includes federal, state, and sometimes local income taxes.

It also includes FICA taxes (social security and Medicare taxes), which are legally required.

1. Federal Income Tax Withholding

This is the most common form of withholding and applies to virtually every employee in the United States.

The amount withheld depends on the employee’s Form W-4, which includes their filing status, number of dependents, and other withholding adjustments.

The IRS provides withholding tables and an online estimator to help determine how much should be withheld.

This withholding is applied toward the employee’s year-end federal tax liability, so the more that’s withheld accurately, the smaller the risk of underpayment penalties or surprise tax bills.

2. State Income Tax Withholding

Not every state imposes an income tax, but for those that do, employers are required to withhold a portion of employees’ wages for state income taxes.

States like California, New York, and Illinois have income tax withholding requirements.

The rules, forms, and tax rates for state withholding vary widely from state to state.

3. Local Income Tax Withholding

In some areas, especially in certain cities, counties, or school districts, employees may also be subject to local income tax withholding.

For example, New York City, Philadelphia, and Columbus (Ohio) have their own local income tax structures. Local tax rates are usually low, but employers still must comply with proper withholding, depositing, and reporting.

4. FICA Taxes (Social Security and Medicare)

FICA stands for the Federal Insurance Contributions Act. These taxes fund Social Security and Medicare, two major federal benefit programs.

This category includes:

Employers must match the employee’s FICA contributions, paying the same amounts from their own funds.

How Tax Withholding Works

Tax withholding is based on the information employees provide in their W-4 form on the first day of joining, during onboarding. It outlines the tax exemptions your employees are claiming.

It again depends on an employee’s filing status:

• Single
• Married filing separately
• Married filing jointly
• Head of household, or qualifying surviving spouse

This has a big impact on tax withholding.There are some states that don’t have state-level income taxes, such as:

• Alaska
• Florida
• Nevada
• South Dakota
• Tennessee
• Texas
• Wyoming

For other states, you will either have a flat or a graduated-rate income tax structure.

Tax withholding is taken out in three stages:

Stage 1

Before calculating how much tax to withhold, employers must first determine the employee’s taxable wages, not just their gross pay.

That means subtracting pre-tax deductions, which are amounts taken out of an employee’s paycheck before taxes are applied. These reduce the employee’s taxable income and, consequently, the amount of tax withheld.

Common pre-tax deductions include:

• Health insurance premiums (medical, dental, vision)
• Life insurance premiums (up to a certain amount)
• 401(k) or other retirement plan contributions
• Health Savings Account (HSA) contributions
• Flexible Spending Accounts (FSAs)
• Commuter benefits in eligible jurisdictions

Example:

This is the amount used to calculate federal tax withholding in the next step.

Also Read: HSA vs FSA: Understanding the Key Differences

Stage 2

Now that you have the taxable income, the next step is to calculate how much tax to withhold.

This includes:

• Federal income tax, based on the employee’s Form W-4
• FICA taxes, comprising:
• Social Security tax (6.2% of taxable wages up to the wage base limit)
• Medicare tax (1.45% of all wages; an additional 0.9% may apply for high earners)

The Form W-4 completed by the employee provides key inputs:

• Filing status (e.g., single, married)
• Number of dependents
• Any extra amount to withhold
• Multiple job considerations

The IRS provides withholding tables in Publication 15-T and an online Tax Withholding Estimator to help employers make accurate calculations.

Payroll software or providers also automate this process using the latest IRS rules.

Example:

Stage 3: Deposit and Report the Withheld Taxes

Once the correct amount of tax has been withheld from the employee’s paycheck, the employer must:

• Deposit the withheld taxes with the IRS and relevant state/local agencies according to the schedule (semi-weekly or monthly, depending on your payroll volume).
• Report these taxes on IRS Form 941 (Employer’s Quarterly Federal Tax Return) or Form 944 (annual filers).
• Provide employees with Form W-2 at year-end, detailing total wages paid and taxes withheld for the calendar year.

It’s critical for employers to comply with deposit deadlines and accurate reporting, as penalties for missed payments or errors can be significant.

How to Withhold Taxes From Supplemental Wages?

The IRS classifies bonuses, commissions, severance, and non-qualified stock options, etc, as supplemental wages.

This is calculated in one of two ways.

1. The Percentage Method

Also known as the flat rate method, and commonly used by employers. In this method, supplemental wages are run on a separate payroll. The major concern is for highly-compensated employees – their tax liability may be greater than their withholdings, which could lead to a surprise bill during tax season.

2. Aggregate Method

In this method, you, the employer, combine an employee’s regular and supplemental wages into gross pay for a pay period, and withhold taxes based on the employee’s W-4. You run only one payroll, very complicated for employers to calculate.

Employee’s Role in Withholding Taxes

• Completing Form W-4 accurately and updating it with a new W-4 every time there’s a new life update
• Check regularly with the IRS website and adjust withholding accordingly

Employer’s Role in Withholding Taxes

• Obtaining the W-4 form from each employee
• If an employee wants to change the federal tax withholding from their regular pay, they must submit a new form W-4 to you
• Withholding all necessary types of taxes regularly
• Paying employer contributions for FICA taxes
• Depositing withheld and contributed taxes
• The IRS has two schedules – monthly and semi-weekly. You have to decide which schedule to adopt before the beginning of each calendar year.
• Deposit the collected taxes through the Electronic Federal Tax Payment System
• File Form 941 each quarter, which is used to report income and FICA taxes withheld from employees’ paychecks and pay the employer portion of the FICA tax.

How to Check If You’re Withholding the Right Amount

Step 1: Ensure Employees Have Submitted an Accurate W-4

The foundation of proper withholding begins with the employee’s Form W-4.

Encourage new hires to complete this form carefully, and remind existing employees to update it whenever their personal or financial situation changes, like marriage, divorce, dependents, or a second job. An outdated W-4 can lead to under- or over-withholding.

Step 2: Use IRS Resources and Updated Tax Tables

The IRS publishes Publication 15-T, which contains the federal income tax withholding tables and calculation methods. If you’re processing payroll manually or maintaining your own system, always ensure you’re using the latest version of these tables. If you’re using payroll software or a provider, make sure their system is updated regularly in accordance with IRS guidelines.

Step 3: Encourage Employees to Use the IRS Withholding Estimator

While you can’t use the IRS Withholding Estimator for your employees, you can guide them to it. The tool, available at irs.gov/withholding, helps employees evaluate whether their current withholding aligns with their expected tax liability.If the results suggest they’re withholding too little or too much, they can submit a revised W-4 to you.

Step 4: Review Payroll Reports Periodically

Run periodic internal audits or reports to double-check that:

• The correct FICA percentages are being applied (6.2% for Social Security, 1.45% for Medicare)
• Withholding amounts match the information on each employee’s W-4
• Any additional withholding amounts (entered on Line 4(c) of Form W-4) are being correctly applied

If you’re managing payroll manually or through spreadsheets, small miscalculations can add up over time, so occasional reviews can help catch issues early.

Simplify Withholding Calculation and Filing with Keka

While withholding is mostly automatic for salaried staff, it still requires careful setup, regular monitoring, and accurate reporting from the employer’s end.

Keka simplifies the entire payroll and tax withholding process by automating calculations, deductions, and compliance reporting, all in one unified platform. When employees submit their Form W-4, Keka automatically applies the appropriate federal, state, and local tax withholding rules using up-to-date tax tables. It handles FICA taxes, additional voluntary deductions, and even custom withholding preferences seamlessly.

For employers, this means accurate and timely tax deductions, automatic deposits and filings with tax authorities, easy access to payroll reports and compliance documents, and real-time payslip generation shows withheld amounts clearly to employees.

Keka also integrates with statutory compliance requirements in multiple regions, helping businesses avoid errors, penalties, or delays. Whether you’re managing a small team or a growing workforce, Keka ensures your withholding tax process is accurate, compliant, and effortless.

FAQ

1. What happens if too much is withheld?

If too much is withheld from an employee’s paycheck, they will typically receive a tax refund when they file their annual tax return. While this isn’t harmful, it means the employee had less take-home pay throughout the year than necessary.

2. What if I owe taxes at the end of the year?

If you owe taxes, it means not enough was withheld during the year. This can result in a tax bill and, in some cases, underpayment penalties. It’s a sign that your withholding may need to be adjusted.

3. Can I change my withholding anytime?

Yes, employees can submit a new Form W-4 at any time during the year to adjust their federal income tax withholding. Employers must implement the changes by the start of the first payroll period ending 30 days after receiving the updated form.

4. What percentage of federal tax should be withheld?

There’s no fixed percentage because withholding depends on each employee’s income, filing status, dependents, and adjustments listed on their W-4. However, for bonuses or supplemental wages, the IRS allows a flat withholding rate of 22% as of 2024.