What Is Federal Tax Withholding?

Gabrielle Sinacola | Oct 10, 2023

What Is Federal Tax Withholding?

Practically every employee in the United States is subject to federal tax withholding. In a nutshell, federal tax withholding keeps a certain amount of your employees’ paychecks to send directly to the government, estimating how much they owe for each tax year.

Understanding the ins and outs of federal tax withholding is crucial for proper compensation, especially if you have employees in multiple states. So, let’s take a closer look.

How Does Withholding Work?

The process of tax withholding generally works like this:

  • An employer calculates an employee’s gross income.
  • Based on the employee’s tax bracket and other factors, the employer withholds income tax each pay period and pays it directly to the IRS on the employee’s behalf.
  • Both the wages paid to the employee and the federal tax withheld are reflected in each employee’s Form W-2, which they receive after the end of the year.

As an employer, you determine just how much money to withhold from each employee by:

  • Calculating the amount of income the employee earned.
  • Analyzing the employee’s filing status and associated tax rate, the number of withholding allowances claimed, and any extra withholdings an employee wants.
  • Determining additional income apart from base salary, like bonuses and commissions.

It’s a good idea to check your withholding process at least once a year (generally in the first half), especially if tax laws change.

What Is the Purpose of Federal Tax Withholding?

There are three main reasons why federal tax withholding is a standard practice and required by law across the United States.

Ensuring Tax Payment Throughout the Year

Withholding federal income taxes from employees helps make sure that the federal government receives proper tax payments throughout the year. This way, people don’t forget to pay their taxes — the tax payments happen automatically, and the government compensates them for any overpayments at tax time (in the form of a tax refund).

Simplifying Tax Returns

Withholding income taxes from your employees can also simplify tax returns, making the process of filing taxes that much easier for everyone involved. Employees can check their paystubs to see how much federal tax was withheld to double-check the accuracy of their tax forms and view their taxable income.

Reducing Tax Underpayment Penalties

In the long term, withholding taxes from your employees helps reduce underpayment penalties, too. Thanks to tax withholding, employees won’t accidentally pay the government too little money, which would cause them to need to pay extra fees later on.

How To Determine the Right Withholding Amount

Since employers can be penalized for not withholding the right amount of federal taxes from their employees, it’s a good idea to know how to determine the right withholding amount from the start. Let’s take a closer look so you can get it right — the first time.

Leveraging Form W-4

Form W-4, also called the Employee’s Withholding Certificate, is a key IRS form every employee should have. With the information in this form, you’ll withhold a portion of your employees’ earned income for federal taxes when you process payroll.

During that process, the employee’s W-4 shows you their wage bracket, which will allow you to quickly determine how much you should withhold for that specific individual. The form will also include information like:

  • Filing status (married filing separately, head of household, single, etc.)
  • Any withholding allowances an employee has claimed
  • Any tax credits or dependents an employee wants to account for in their federal income taxes

Adjusting Withholding for Life Events

From time to time, employees might go through life events that call for them to change their tax bracket or status. Say that an employee gets married, for example — they may now have to pay less federal income tax.

If the employee wants to change their filing status, they’ll need to submit a new Form W-4. Then, the next time you process payroll, you can input the employee’s new information to update the amount of tax being withheld.

Financial advisor and Partner at Fike Advisors, Taylor Fike, notes that oftentimes, employees forget to include their partner’s income when trying to inform the employer about their withholding amount. “Be sure to accurately estimate the tax bracket by taking the gross income of both partners into consideration.”

Using the IRS Tax Withholding Estimator

As an employer, you can also offer your employees the option to use the IRS withholding estimator. With this handy tool, employees can estimate their federal income tax withholding and choose a withholding amount that works for them. Employees still need to specify a filing status and determine the number of withholding allowances they want to claim on their W-4 forms, but this can still be a valuable tool to ensure everyone is taxed appropriately.

What Are Some Common Withholding Considerations for Businesses?

As you might guess, you’ll need to keep some pretty significant withholding considerations in mind — particularly if you manage payroll for employees across several states.

Multi-State Operations

What if you have employees across different states, or what if your employees work in states other than their home state? In this case, you have a multi-state payroll.

If you have employees in several states, you’ll need to withhold employee taxes for the federal government as well as individual state taxes. The only exceptions are the following nine states, which don’t have state income tax:

  • Alaska
  • Florida
  • Nevada
  • New Hampshire
  • South Dakota
  • Tennessee
  • Texas
  • Washington
  • Wyoming

If your employee works in a state other than their home state, you’ll need to consult with your legal counsel for correct withholding based on the business status and work performed. You may be required to withhold income tax based on the state in which the services are performed. For example, say you run a restaurant in New Mexico near the Texas border. You’ll withhold state income taxes under the New Mexico system, even if an employee lives in Texas.

Handling Employee Concerns

As an employer, it’s important that you handle employee concerns regarding withholding estimates, tax status, and more. Be prepared to answer questions from employees regarding how much money is withheld and what they can do to change their filing status.

What Are Some Withholding Mistakes To Avoid?

Performing federal tax withholding properly is crucial, but so is avoiding easy mistakes! Here are a few examples.

Under-Withholding and Over-Withholding

The last thing you want to do is under or over-withhold taxes. Under-withholding taxes means not withholding enough employee taxes each year, which means your employees are faced with a tax bill in the spring.

Over-withholding is the opposite — while your employees won’t know, you’ll essentially be underpaying them, which can get you into hot water with the IRS and result in severe fines. Use software tools and IRS withholding estimators to make sure you withhold exactly the right amount for each employee.

Fike also notes that having an annual meeting with each employee after their tax filing deadline can be a good idea. This way, any adjustments for withholding can be planned for ahead of time, rather than after penalties are assessed.

Failing To Deposit Withholdings

Taking money out of your employees’ paychecks is one thing, but depositing that money is another. As a business owner, you need to remember to deposit withholdings promptly each month.

The IRS requires you to deposit monthly payroll taxes on the 15th day of the following month. For example, if you are withholding taxes for the month of September, you need to deposit those by October 15.

You should also deposit those taxes using the Electronic Federal Tax Payment System (EFTPS). This is the same system you use to file taxes or estimated income taxes as a freelancer or small business owner in many cases.

Neglecting State-Specific or Local Regulations

Don’t forget that states have their own tax withholding regulations, too. For instance, Texas employees don’t need to pay state income tax, so federal withholding is all that’s necessary. Be sure to brush up on your state’s withholding requirements to ensure you follow the proper process every time.

Some states also have “reciprocal” laws. For example, if an employee works in Missouri but lives in Kansas — Kansas and Missouri have a reciprocal tax agreement. In that case, the Missouri employer can withhold Kansas taxes for the employee who lives in Kansas but works in Missouri. This can get quite complex, once more highlighting the value of using specialized tools for your withholding process.

Local income tax is also key to keep in mind — local income taxes may be applicable in towns, cities, counties, or school districts, and while they are generally lower than federal or state income taxes, it’s important to ensure compliance with these tax requirements to avoid under-withholding.

What Are Some Tools for Proper Withholding?

Since withholding taxes from your employees is so crucial, you need to use the right tools to both minimize your workload and ensure accurate tax withholding.

That’s where Mosey can help. Our state-of-the-art, comprehensive tool organizes all of your payroll compliance to streamline payroll data and let you know when you need to open payroll accounts — like withholding, unemployment insurance, workers compensation, and paid family leave — in new states and localities.

Mosey makes it easy to set up tax accounts, register locally with your secretary of state office, and stay organized across compliance requirements, including insurance and HR compliance.

Simplify Compliance With Mosey

All in all, knowing how to practice federal tax withholding properly is a key part of being a smart, savvy business owner. Fortunately, you don’t have to do it alone — tools like Mosey can make it easier than you think. Give Mosey a try today and simplify your tax processes across the board. Schedule a demo with our team.

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