Income Tax Withholding

Each time you start a new job, one of the first things you do is complete a Form W-4. Do you know why?

Your employer uses your Form W-4 to ensure the correct federal income tax is withheld from your paycheck. Have you ever wondered why you pay a federal income tax? To find the answer, you need to take a look back in history. It used to be that the U.S. government relied mainly on customs taxes for income, but that changed as a result of the enormous cost of the Civil War (1861-1865). This cost led to the creation of the first federal income tax. Initially, tax money was distributed to the states. In 1913, however, the 16^th Amendment was passed giving the government the power to collect income taxes in any form without allocating funds to the states.

The government discovered that many people didn't pay the income tax, either because the exemption level was too high or because they just didn't feel like it. The government resolved the problem in 1942 by creating the Income Tax Withholding System where income tax would be paid on an ongoing basis, or pay-as-you-go. This is the same system that's in place today.

How It Works

Your employer is responsible for withholding a percentage of your salary based on your:

• Marital status – single or married

• Number of allowances – either an exemption, credit, or other benefit you plan to claim when you file your tax return

This information is listed on your Form W-4, the Employee's Withholding Allowance Certificate. Be sure to complete the Personal Allowances, and the Deductions and Adjustments worksheets attached to the form to determine your correct withholding.

More About Allowances

The more allowances you enter on your W-4 form, the less income tax the government withholds from your pay. This increases the amount of money you take home. It might sound as if you should claim a large number of allowances in order to take home more money each payday. However, if you don't pay enough taxes throughout the year, you may have to pay an underpayment penalty. In order to avoid paying a penalty next year, your income tax payments throughout the year must equal the lesser of:

• 90% of this year's tax

• 100% of last year's tax

Exceptions to the underpayment penalty are:

• Your total tax due is less than $1,000

• You had no tax liability last year

Verify Your Withholding Amount

It's a good idea to be sure you don't have too much or too little tax withheld. If you have too little withheld, you'll owe money when you file your taxes. If you have too much withheld, you'll get a refund. Getting a large refund may be desirable to some, but it means you've given the government what amounts to an interest-free loan when you could have been using the money for something else during the year.

You may want to review your withholding amount when:

• You had a big refund last year

• You owed more money last year than you could comfortably pay

• You owed a penalty last year

• Your tax liability has been affected by tax law changes

• You had a life or financial situation change that affects the number of exemptions you can claim – you have 10 days after the event to file a new Form W-4 with your employer

To determine your correct withholding, read IRS Publication 505, Tax Withholding and Estimated Tax and Publication 919, How Do I Adjust My Tax Withholding? Both publications are available at www.irs.gov. Complete the worksheets in each publication and compare them. If you see you should increase your withholding amount, you could:

• Decrease the number of allowances

• Enter an additional amount to be withheld from each paycheck

If, however, you find you should decrease your withholding amount, you could increase your number of allowances.

Where Does the Money Go?

While your income tax is withheld, the government uses it for various things, such as:

• National Defense and Security

• Education (including student loans)

• Health Research and Regulation

• Transportation (highways, air, railroads, and mass transit)

• Law Enforcement and Justice Administration

To see how your income taxes are spent by the federal government, look at thebudgetgraph.com poster Death and Taxes: A Visual Guide to Where Your Federal Tax Dollars Go.

It may be stressful to see your paycheck decreased by the amount of your withholding, but the money is used to benefit you. Review your Form W-4 each year to ensure you're withholding the correct amount for your situation. To learn more about taxes, read the related articles in our Knowledge Center Library.

Take control of your finances with our debt help tools. Use our calculators and budget planner to help you manage your money.

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