Withholding Wages – How it Works

All earned “gross income,” as defined by the Code, is subjected to the federal income tax. More specifically, the federal government imposes a general income tax, Social Security tax, as well as a Medicare tax on wage-earners. All three taxes are, by law, deducted automatically from a taxpayer’s paycheck. The rationale behind the automatic deduction system is simple: the Treasury has an immense interest in ensuring it maximizes its tax revenue. Thus, involuntary, up-front collection is effective in avoiding an otherwise inevitable taxpayer non-compliance problem.

While both Social Security and Medicare taxes are not recoverable by the taxpayer, portions of the general income tax can, in some situations, be recovered by filing a return. For this reason alone, all wage-earners earning any sum of money should file a return. The amount a taxpayer may receive back from the IRS, however, depends greatly upon his final tax liability as well as his placement within the six-rate tax tables.

The withholding-recovery process is as follows: First, all new employees file a Form W-4 on which they select what percentage of wages are to be withheld from each paycheck. A taxpayer should select a percentage similar to the tax bracket rate he anticipates falling within by year’s end. Doing so will minimize the probability that the government withholds too little or too much of his wages (which could result in the unfortunate “loaning” of money to the government tax-free). Next, the taxpayer, while preparing his return, will determine his tax liability (the money he owes the federal government). Finally, the taxpayer will compare that value with the amount of wages that were withheld from his paycheck throughout the year. If the government has withheld a greater amount of money than his tax liability, the taxpayer is entitled to a tax refund. If the reverse is true, the taxpayer will not be able to recover any withheld income and will actually owe the balance.

 Photo by: Steve Wampler Photography