The term withholding tax refers to a tax that is withheld by the payer and remitted directly to the government entity imposing the tax. Federal income tax, deducted by an employer from an employee's paycheck, is the most common form of withholding tax in the United States.
Also referred to as a retention tax, withholding tax is an obligation the payer has to withhold a portion of the payment made to another party. While withholding taxes usually apply to wages paid by employees, this responsibility can also apply to non-residents receiving dividend and interest income derived from securities.
In the United Sates, federal income taxes, Social Security, and Medicare are federal taxes employers need to withhold from their employees' paychecks in addition to state-level income taxes. Employers are also responsible for sending withholding taxes to the government entities imposing each tax.
The total amount of money withheld each year is then credited to the employee's account. A tax return is used to reconcile the amount of tax withheld to the amount of tax owed. If the return indicates overpayment, the government agency would issue the taxpayer a refund. If the return indicates underpayment, the taxpayer is required to remit the amount owed along with their tax return.
Withholding taxes ensure that governments receive the operating revenues they need to provide the essential services they deliver to citizens. They're also deemed an effective way to reduce tax evasion.