The federal income tax withholding system was implemented in 1943 through the Current Tax Payment Act, according to the Cato Journal. This system made it legal for the government to collect the resources necessary to fund national programs, such as the welfare system. Federal withholding refers to the federal payroll taxes that employers are required to withhold from employees’ wages.
Federal income tax is a form of tax that the federal government levies on personal income. Social Security and Medicare—also called FICA— taxes are forms of payroll taxes that the federal government also imposes on income. Employees pay these federal payroll taxes via the withholding process. Notably, self-employed individuals pay these taxes as well, but are not subject to the actual withholding process due to the absence of an employer.
The Internal Revenue Service is the federal agency responsible for administrating federal tax laws. According to the IRS, in 2009, it processed more than 236 million tax returns and collected more than $2.3 trillion in earnings. The IRS instructs employers how to comply with federal withholding laws via its Circular E publication.
Federal income tax withholding is based on the employee’s filing status, allowances, and the Circular E’s withholding tax tables. The IRS requires employers give new employees a W-4 form to complete. The employee states her withholding conditions on the form, such as filing status, allowances, additional tax to be withheld per paycheck, or exempt status. If the employee is exempt, the employer does not withhold federal income tax. If the employee does not submit a W-4, the employer can withhold at single filing status with zero allowances.
The IRS gives employees a certain amount for each allowance claimed on the W-4. For 2010, the amount per allowance for a weekly payroll is $70.19. Therefore, for a biweekly payroll, which is based on two weeks’ pay, the amount per allowance would be $140.38. The employer cannot guess the withholding amount but must use the Circular E, which gives the exact amount of federal income tax to withhold based on the employee’s income, pay period, filing status, and allowances.
The employer withholds Medicare tax at 1.45 percent of all gross earnings and Social Security tax at 6.2 percent of gross earnings, up to $106,800 for the year. The employer also pays this amount. Self-employed individuals pay the full Medicare amount of 2.9 percent and Social Security amount of 12.4 percent because they do not have an employer to pick up the matching portion.
The IRS requires employers to report and pay all federal income tax and FICA tax withholdings, and the employer’s portion of FICA taxes, according to the schedule the IRS mandates. The employer files W2s with the Social Security Administration to report annual wages and taxes withheld for each employee.
- Department of the Treasury Internal Revenue Service: (Circular E), Employer's Tax Guide
- Department of the Treasury Internal Revenue Service: Form W-4 (2010)
- The Cato Journal: Evolution of Federal Income Tax Withholding: The Machinery of Institutional Change
- IRS.gov: Understanding Taxes
- IRS.gov: The Agency, its Mission and Statutory Authority
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