If you haven't filed your taxes yet you may be in for a shock. Tax refunds are down, and some people accustomed to receiving checks are actually having to cut one.

To understand why, first you need to understand tax withholding.

What Is Withholding?

Most Americans think of April 15 as Tax Day, that moment every year when the IRS collects its due. But this isn't entirely accurate, or even accurate at all.

In fact the IRS taxes all Americans constantly over the course of the year. For business owners and the self-employed this comes in the form of quarterly taxes. Anyone who makes their own money has to file and pay every three months, if they earn enough to owe taxes.

Workers who collect a W-2 paycheck have it a little bit simpler. Based on how you fill out your W-4 your employer estimates what percent of each paycheck you'll owe in taxes. They withhold that amount (hence the term) and pay the IRS on your behalf, again typically on a quarterly basis. The employer uses a formula provided by the IRS to determine this tax rate. (The 41 states with an income tax use a substantially similar system as well.)

This is the withholding tax, the amount of money kept out of each paycheck to cover that pay period's state and federal taxes.

Why Does the IRS Require Withholding?

Withholding is applied, chiefly, to ensure that the government receives its money.

The IRS has withheld taxes annually since 1943 when the government cited wartime needs as a reason for this form of collection. The idea wasn't entirely novel. The IRS had withheld income tax during World War I, and less than a decade earlier Social Security introduced a nationwide payroll tax.

What changed in 1943 was scope. Up until World War II only 4% of the country paid anything in federal income tax and less than a fifth of Americans even bothered with filing a return. The citizens that did pay were generally quite wealthy, the sort who live public lives with easily-located assets.

As a result the government collected its taxes in arrears. Taxpayers owed income taxes by March 15 in full, and their numbers were sufficiently few that auditors could keep up.

With the onset of World War II and the Revenue Act of 1942 the number of tax returns collected by the IRS leapt to from 26 million to 40 million, and nearly two-thirds of Americans now owed income taxes. The challenge, as the New York Times put it at the time, was how "to insure collection… [and] ease the taxpayer's method of payment." 

The solution was withholding. Instead of having citizens wait until the end of each year to pay their taxes in one lump sum the government would collect it a little bit at a time out of each paycheck. To make such a vast system workable, Congress imposed the duty of calculation and payment on employers.

At the beginning withholding was a partial exercise in real politics. The U.S. government had passed a truly massive expansion of the income tax to pay for World War II and hoped that it could avoid the politics of sticker shock by collecting a little bit at a time.

Today it's about real finance. Few middle class Americans have the savings to pay their taxes all at once. Ideally in the absence of withholding the average citizen would keep and save for their annual tax bill, but in reality that's unlikely.

Withholding helps Americans pay their taxes more easily, even though all are required to file an annual return. It helps the government maintain a steady cash flow through regular income, rather than a feast-or-famine model. Mostly, though, it prevents annual shock for Americans who would have to scrounge up hundreds or maybe thousands of dollars in April for the IRS.

How Can You Still Owe Taxes?

The key issue to withholding is that it is not your actual income tax. It's simply a collection estimate based on the information filled out in your W-4 and a formula provided by the IRS. As a result, at the end of each year it's your obligation to fill out a 1040 and calculate your actual tax burden based on all sources of income.

In ordinary years the IRS tries to overshoot on its estimates. While critics argue this is so that the government can keep more of your money, in reality it has more to do (again) with collection and perception. The government would much rather send out refund checks than audit notices, and taxes are far easier to enforce when the average citizen never sees that money in the first place.

If you or your employer overestimated the withholding, that's exactly what happens. The IRS got too much from your paycheck so you get some of it back.

The opposite also holds true. If the agency underestimates a taxpayer's obligations, the taxpayer owes the remainder when they file. On average more than 70% of citizens who owe income tax receive a refund at the end of the year, which is why it has come as a shock for some to find that they owe money in 2019.

Taxpayers can adjust their rate of withholding at will. By filing a new W-4 they can increase or decrease the amount held back from each paycheck, even all the way down to zero if the taxpayer would like to pay their taxes entirely independently. However, a taxpayer who pays less than 90% of their total taxes over the course of a calendar year may owe an additional penalty when they do, ultimately, file.

The IRS and Congress have also explored eliminating tax returns altogether for the average citizen, relying instead on withholding as the sole form of tax collection for most payers. A five year study released by the Treasury in 2003 found that, while viable, return-free taxes would require sweeping simplification of the tax code and significantly more data collection on the average citizen.

Withholding Tax vs. Payroll Tax

Withholding and payroll taxes are structurally similar. In both cases your employer holds back a portion of your paycheck, sending it directly to the government instead of ever giving it to you.

The chief difference is that withholding is not actually a tax. As discussed, it is a means of collecting the federal income tax. The payroll tax, on the other hand, is an independent tax dedicated to Medicare and Social Security.

While withholding rates can vary without ever affecting your final bill, the sum total of your payroll tax is deducted from each paycheck. (This is true, again, for all W-2 employees. Workers such as business owners and the self-employed must pay their own payroll taxes.)

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