Withholding Tax or the retention tax is a way of deducting tax at the source of the income to avoid collecting tax after the income is earned. Usually, it is the amount withheld by the employer from the employee’s income. The employer then pays it directly to the government. When the employee files his tax return, they can take credit for this withholding tax.
For example, Mr. A has an annual salary of $60000, or $5000 per month. However, he brings home only $4500 at the end of each month. Assuming there are no other deductions, Mr. A‘s employer withheld $500 each month and pays it to the government as a tax on behalf on Mr. A.
In simple words, we can say it is the money taken out from an employee’s income to pay taxes in advance that they would be liable to pay later. This tax can also be levied on interest and dividend income from the securities. Moreover, it applies to both residents and non-residents of a country.
Such a type of tax is present in almost all tax systems. Moreover, such a tax is mainly applicable to income from wages, royalties, dividends, interest, and more.
Withholding taxes were introduced during the term of President Abraham Lincoln in 1862. It was introduced primarily to fund the Civil War. After the Civil War, such tax was abolished but was again picked up in 1943. At the time, the thinking was it would become very difficult to collect taxes if not collected from the source. At the time of hiring, the employee needs to fill out a W-4 Form, which helps estimate the taxes.
Types of Withholding Tax
In the US, two different types of withholding tax are in use that ensures incomes are taxed in every situation. These are:
Resident Withholding Tax
Collecting this tax is the responsibility of every employer in the US. Usually, an employer collects this tax and then remits the same to the government. In this case, the employee will have to pay the remaining tax (if any) when they file the return later. If the employer withheld more taxes, then the employee would be eligible for a refund.
It is desirable that the employer withholds the maximum tax that an employee is liable to pay. This ensures that employees pay most of their tax on time. Otherwise, they need to pay a heavy fine.
One can also make use of a tax withholding estimator to ensure that they pay the correct amount of tax. A point to note is that the independent contractors and investors are not liable for a withheld tax.
Nonresident Withholding Tax
This form is for the nonresident to ensure that they pay all the taxes from the income generated using the US resources. A non-resident is a person who is foreign-born and has not cleared the green card test or any other similar test. Such people need to file Form 1040NR if they do business in the US.
Withholding Tax – What’s the Use?
- As said above, this tax makes it easier for the authorities to collect total taxes.
- It relieves the taxpayer from paying a big amount in one go. Instead, it breaks the taxpayer’s liability into smaller monthly payments.
- This tax also ensures regular cash flows for the government, which can use it for social security measures.
How it’s Different from TDS?
After reading the above points, you may have got a feeling that withholding tax is the same as the TDS. You are not totally wrong if you think so, as there is a very marginal difference between the two. An employer deducts TDS at the time of making a payment. On the other hand, the employer deducts withholding tax in advance or before making a payment.
However, in some countries, the two terms are the same, but their usage is different. This means TDS applies when dealing with the resident while withholding tax comes into use for the non-residents.
All US states make use of tax withholding systems to collect taxes from residents and non-residents. These states use a mix of IRS W-4 forms and other forms to determine the real tax liability of a person. After collecting the taxes, these states use the proceeds to fund various social security measures.