Withholding taxes gives the Government part of your income before you have a chance to use it. Withholding tax is imposed on salary and wage income, tip income, certain gambling winnings, pensions, and retirement distributions, but you may avoid withholding on retirement payments (26.10). Withholding is also imposed on interest and dividends if you do not give your taxpayer identification number to a payer of interest or dividend income.

You may increase or decrease withholdings on your wages by submitting a new Form W-4 to your employer. Withholdings may be reduced by claiming allowances based on tax deductions and credits.

Make sure that tax withholdings meet or help you meet the estimated tax rules that require withholdings plus estimated tax payments to equal 90% of your current year liability or the required percentage of the prior year’s liability; see Chapter 27.

A mandatory 20% withholding rate applies to eligible rollover distributions that are paid to you from an employer retirement plan. You may avoid the withholding by instructing your employer to directly transfer the funds to an IRA or the plan of a new employer (26.9).

26.1 Withholdings Should Cover Estimated Tax

In fixing the rate of withholding on your wages, pay attention to the tests for determining whether sufficient income taxes have been withheld from your pay. A penalty will apply if your wage withholdings plus estimated tax payments (including prior year overpayments credited to current estimated tax) do not equal the lesser of 90% of your current tax liability or the required percentage of the prior year’s tax (27.1).

Taxes are withheld from payments made to you for services that you perform as an employee, subject to certain exceptions (26.2). On Form W-4, you can claim allowances on Line 5 for yourself, your spouse, and dependents, as well as withholding allowances for itemized deductions and tax credits such as the child tax credit and the child and dependent care credit. The number of allowances claimed will either decrease or increase the amount of withholding.

If you need to increase your withholding, such as to cover investment or self-employment income, you can choose not to claim all of the allowances allowed on Form W-4, or increase withholdings even more by claiming “0” (zero) allowances on Line 5. If married, you can select on Line 3 for withholding to be at the higher rate for single persons. You can also direct your employer to withhold an additional flat amount from each paycheck on Line 6 of Form W-4.

You can change your withholdings, either increasing or decreasing them, if your financial or family situation changes (26.4).

26.2 Income Taxes Withheld on Wages

The amount of income tax withheld for your wage bracket depends on your marital status and the number of allowances you claim. You file a withholding certificate, Form W-4, with your employer, indicating your status and allowances. Without a Form W-4, your employer must withhold tax as if you are a single person with no exemptions.

Cash payments or the cash value of benefits paid to an employee by an employer are subject to withholding, unless the payments are specifically excluded.

Income Taxes Are Withheld on:

• Payments by your employer for salaries, wages, fees, commissions, vacation allowances, severance pay, and other payments for services performed (whether paid in cash or goods).You generally may elect to avoid withholding on pensions and retirement annuities (26.10). If supplemental wages (payments that are not regular wages) such as bonuses, commissions, overtime pay, accumulated leave, or taxable expense allowances (under nonaccountable plans) are separately identified from regular wages, an employer may withhold at a flat rate of 25% for the supplemental wages instead of using the regular withholding tables.
• Sick pay paid by your employer. If a third party pays you sick pay on a plan funded by your employer, you may request withholding by filing Form W-4S.
• Taxable group insurance coverage over $50,000.
• Reimbursements of expenses that do not meet qualifying rules of accountable plans discussed in 20.31. Also, reimbursements from accountable plans that exceed federal rates if the employee does not return the reimbursement or show that it is substantiated by proof of expenses.
• Pay to members of the U.S. Armed Forces. Differential wages paid by an employer to a former employee while on active military duty are subject to withholding.
• Prize awarded to a salesperson in a contest run by his or her employer.
• Retroactive pay and overtime under the Fair Labor Standards Act.
• Taxable supplemental unemployment compensation benefits.

Income Taxes Are Not Withheld on:

• Earnings of self-employed persons; they may pay estimated tax installments throughout the year (27.2).
• Payments to household workers. However, although income tax withholding is not required, the worker and the employer may make a voluntary withholding agreement; see Chapter 38.
• Value of tax-free board and lodging furnished by an employer.
• Fringe benefits not subject to tax.
• Substantiated reimbursements for deductible moving expenses or medical care benefits under a self-insured medical reimbursement plan.
• Advances for traveling expenses if the employee substantiates expenses to the employer and if the employee returns any unsubstantiated amount (20.31).
• Pay for U.S. citizen working abroad or in U.S. possessions to the extent that the pay is tax free (36.1).
• Payments to agricultural workers, ministers of the gospel (except chaplains in the Armed Forces), nonresident aliens, public officials who receive fees directly from the public, notaries, jurors, witnesses, precinct workers, etc.
• Death benefit payments to beneficiary of employee; wages due but unpaid at employee’s death and paid to estate or beneficiary.

Form W-2. By January 31, 2018, your employer must give you duplicate copies of your 2017 Form W-2, which is a record of your pay and the withheld income tax, Social Security and Medicare taxes. If you leave your job or your employment is terminated and you request a Form W-2 from the employer, you should receive it within 30 days of the request or, if later, within 30 days of your final wage payment.

26.3 Low Earners May Be Exempt From Withholding

If you had no income tax liability in 2017 and expect none for 2018, you may be exempt from income tax withholdings on your 2018 wages. If eligible for an exemption, students working for the summer, retired persons working part time, and other part-time workers do not have to wait for a refund of withheld taxes they do not owe. The exemption applies only to income tax withholding, not to withholdings for Social Security and Medicare (26.8).

If you cannot be claimed as a dependent by another person, you can claim the exemption from withholding if last year you had no tax liability and this year your total income is expected to be no more than the sum of your personal exemption and the standard deduction for your filing status. However, if you can be claimed as a dependent on another person’s tax return and are under age 65, the exemption from withholding is not allowed if your expected total income (wages and investments) and investment income exceeds annual limits. For 2017, the total income limit was $1,050 and the investment income limit was $350. These amounts may be increased by an inflation adjustment for 2018, and if so, the revised amounts will be on the Form W-4 for 2018.

To claim an exemption for 2018, you must file Form W-4 with your employer, and certify your eligibility on Line 7. If you will file a joint return for 2018, do not claim an exemption on Form W-4 if the joint return will show a tax liability. An exemption claimed during 2017 expires February 15, 2018.

26.4 Are You Withholding the Right Amount?

You do not want to withhold too little from your pay and you do not want to withhold too much. You may need to withhold more to avoid a large tax payment or an estimated tax penalty (26.1) when you file your return, especially if you have substantial income from investments or a business.

On the other hand, if you have been receiving large refunds from the IRS, you may want to consider reducing your Form W-4 allowances to avoid over-withholding. Balance the loss of the use of your earnings during the year against the value of receiving a substantial refund check from the IRS after you file your return.

If you are starting a new job or if you have not changed your withholding allowances in several years, review the Form W-4 worksheets to help you determine if you are withholding the right amount.

Working couples filing jointly should figure withholding allowances on their combined wage income, deductions, adjustments, and credits, but can divide the total number of allowances between them in any way they wish. On separate returns, the allowances must be figured separately.

If you work for only one employer and are unmarried, you may claim an additional withholding allowance. If you are married, you may claim the additional allowance if you work for only one employer and your spouse does not work, or your wages from a second job or your spouse’s wages are $1,500 or less. This special allowance is only for withholding purposes. You may not claim it on your tax return.

If you work for two or more employers at the same time, you figure your withholding allowances based on the total income, and then split the allowances between the two jobs in any way you wish. Do not claim the same allowances with more than one employer at the same time.

File a new Form W-4 each year for withholding allowances based on your anticipated deductions and credits. Keep in mind that a phaseout applies to total itemized deductions if your adjusted gross income (AGI) exceeds the threshold for your filing status (13.7).

Furthermore, you may have to file a new form to increase your withholding if withholding allowances you had been claiming are no longer allowed.

IRS review of Form W-4. Employers are not required to submit Forms W-4 to the IRS for review unless the IRS sends written notice directing the employer to provide the W-4 forms of specified employees. The IRS uses the information on Form W-2 wage statements to spot employees who are not withholding enough federal income tax from their income. If the IRS determines that too many withholding allowances are being claimed, the IRS can issue a “lock-in letter” requiring your employer to limit the number of allowances to a specified maximum. You will receive a copy of the “lock-in letter” and be given an opportunity to dispute the IRS determination before your employer adjusts your withholding.

The IRS may impose a $500 civil penalty if you did not have a reasonable basis for claiming allowances that reduced your withholding on Form W-4. There is also a criminal penalty for willfully supplying false information on Form W-4. Upon conviction, there could be a fine of up to $1,000, a jail sentence of up to a year, or both.

When to file a new Form W-4. You should file a new Form W-4 any time the number of your exemptions or withholding allowances increases or decreases, such as when a child is born or adopted, you marry, you get a divorce, or your deductible expenses change.

Your employer may make the new Form W-4 effective with the next payment of wages. However, an employer may postpone the new withholding rate until the start of the first payroll period ending on or after the 30th day from the day you submit the revised form.

26.5 Voluntary Withholding on Government Payments

You can choose to have federal income tax withheld from Social Security benefits (and equivalent tier 1 Railroad Retirement benefits), unemployment compensation, crop disaster payments, distributions from Alaska Native Corporations, and Commodity Credit Corporation loans. The withholding request is made on Form W-4V. Electing to have tax withheld may eliminate the need to make estimated tax installments (27.2).

For unemployment compensation you may choose a withholding rate of 10%; this is the only rate you can choose. For Social Security and the other payments, you may select a withholding rate of 7%, 10%, 15%, or 25%. If you elect withholding and later decide to stop it, you can do so on a new Form W-4V.

26.6 When Tips Are Subject to Withholding

Tips are subject to income tax and FICA (Social Security and Medicare) withholdings. If you receive cash tips amounting to $20 or more in a month, you must report the total amount of tips received during the month to your employer on Form 4070 (or a similar written report). Include cash tips paid to you in your own behalf. If you “split” or share tips with others, you include in your report only your share. You do not include tips received in the form of merchandise or your share of service charges turned over to you by your employer. Make the report on or before the 10th day after the end of the month in which the tips are received. (If the 10th day is a Saturday, Sunday, or legal holiday, you must submit the report by the next business day.) For example, tips amounting to $20 or more that are received during January 2018 are reported by February 10, 2018. Your employer may require more frequent reporting.

You are considered to have income from tips when you receive the tips, even if they are not reported to the employer.

Your employer withholds the Social Security, Medicare, and income tax due on the tips from your wages or from funds you give him or her for withholding purposes. If the taxes due cannot be collected on the tips, either from your wages or from voluntary contributions, by the 10th day after the end of the month in which tips are reported, you have to pay the tax when you file your income tax return.

Penalty for failure to report tips. Failure to report tip income of $20 or more received during the month to your employer may subject you to a penalty of 50% of the Social Security and Medicare tax due on the unreported tips, unless your failure was due to reasonable cause rather than to willful neglect.

Tips of less than $20 per month are taxable but not subject to withholding.

Tip allocation reporting by large restaurants. To help the IRS audit the reporting of tip income, restaurants employing more than 10 people on a typical business day must make a special report of income and allocate tips based on gross receipts. For purposes of the allocation, the law assumes tip income of at least 8%. If you voluntarily report tips equal to your allocable share of 8% of the restaurant’s gross receipts, no allocation will be made to you. However, if the total tips reported by all employees is less than 8% of gross receipts and you do not report your share of the 8%, your employer must make an allocation based on the difference between the amount you reported and your share of the 8% amount. The allocated amount is shown in Box 8 of your Form W-2. However, taxes are not withheld on the allocated amount. Taxes are withheld only on amounts actually reported by employees. An employer or majority of employees may ask the IRS to apply a tip percentage of less than 8%, but no lower than 2%.

Reporting allocated tips. Your employer will show allocated tips in Box 8 of your Form W-2. However, this amount will not be included in Box 1 wages and you must add it to income yourself by reporting it on Line 7 of Form 1040. You also must compute Social Security and Medicare tax on the allocated tips on Form 4137 and enter the tax from Form 4137 on Line 58 of Form 1040. You may not use Form 1040A or Form 1040EZ.

26.7 Withholding on Gambling Winnings

Gambling winnings are generally reported by the payer to the IRS and to the winner on Form W-2G if the amount paid is $600 or more and at least 300 times the amount of the wager. The payer has the option of reducing the amount paid by the wager in applying the $600 test.

Different reporting rules apply to winnings from poker tournaments, keno, bingo, and slot machines. Winnings from slot machines or bingo games of $1,200 or more, not reduced by the wager, are reported on Form W-2G. Poker tournament winnings are reported on Form W-2G if they exceed $5,000, reduced by the wager or buy-in. Keno winnings are reported on Form W-2G if they are $1,500 or more, reduced by the wager.

Withholding. Your winnings from gambling are subject to 25% withholding if your winnings minus the wager exceed:

1. $5,000 from lotteries, sweepstakes, and wagering pools, whether or not state-conducted, including church raffles and charity drawings, or
2. $5,000 from pari-mutuel pool wagers on horse races, dog races, or jai alai if the proceeds are at least 300 times as large as the amount wagered.

Winnings from slot machines, bingo, keno, or poker tournaments are exempt from the 25% withholding rule. However, “backup” withholding at 28% applies to reportable slot, keno, bingo, or tournament poker winnings if you do not provide a taxpayer identification number (TIN) to the payer; see the Caution on this page.

If your winnings exceed the $5,000 threshold, 25% withholding applies to your gross winnings less your wagers, and not just the amounts over $5,000. Any withholdings will be shown on Form W-2G.

The IRS requires you to tell the payers of gambling winnings if you are also receiving winnings from identical wagers; winnings from identical wagers must be added together to determine if withholding is required.

If you have agreed to share your winnings with another person, give the payer a Form 5754. The payer will then prepare separate Forms W-2G for each of you.

26.8 FICA Withholdings

FICA withholdings are employee contributions for Social Security and Medicare coverage. Your employer is liable for the tax if he or she fails to make proper withholdings. The amount withheld is figured on your wages and is not affected by your marital status, number of exemptions, or the fact that you may be collecting Social Security benefits. On Form W-2, Social Security withholdings are shown in Box 4 and Medicare withholdings in Box 6.

Subject to FICA tax are your regular salary, commissions, bonuses, vacation pay, cash tips, group-term insurance coverage over $50,000, the first six months of sick pay, and contributions to cash or deferred (401(k)) pay plans or salary-reduction contributions to a simplified employee pension (SEP), SIMPLE IRA, or tax-sheltered annuity. Severance pay to laid-off employees is also subject to FICA tax (the U.S. Supreme Court held this in 2014).

FICA tax does not apply to the value of tax-free meals and lodgings (3.12), or to reimbursements for substantiated travel or entertainment expenses or moving expenses.

Excess Social Security and Railroad Retirement withholding. If you have worked for more than one employer during 2017, attach all Copies B of Form W-2 to your return. Withholdings for Social Security taxes are shown in Box 4 of Form W-2. Check to see that the total withheld in 2017 by all your employers does not exceed the annual limit for Social Security taxes. The maximum 2017 liability for Social Security is $7,886.40, 6.2% of the first $127,200 of salary income. If too much was withheld, claim the excess as a credit against the tax you owe on Line 71 of your 2017 Form 1040. On Form 1040A, the excess is included on the line for total tax payments; you cannot claim the excess on Form 1040-EZ.

Employees covered by the Railroad Retirement Tax Act (RRTA) receive Form W-2, which lists total wages paid and withholdings of income and Railroad Retirement taxes. Follow tax form instructions for claiming a credit for excess Railroad Retirement withholding.

If any one employer withheld too much Social Security or Railroad Retirement tax, you cannot claim the excess on your income tax return. You must ask that employer for a refund of the excess and if the employer refuses, get a record of the overpayment and file for a refund on Form 843.

Medicare tax withholding. Medicare tax is withheld at a rate of 1.45% on all salary and wage income; the amount is shown in Box 6 of Form W-2. In addition, if you had wages exceeding $200,000, your employer withheld the 0.9% Additional Medicare Tax on the excess, and this withholding is included in Box 6. See 28.2 for further details on the 0.9% Additional Medicare Tax.

Wages you pay to your spouse or child. Wages you pay to your spouse for working in your business are subject to FICA tax and income tax withholding. Wages you pay to your child are subject to income tax withholding but if your child is under age 18 and your business is a sole proprietorship or a partnership in which the only partners are you and the child’s other parent, the wages are exempt from FICA taxes. Wages you pay to your child under age 21 or to your spouse for domestic work or child care in your own home are exempt from FICA.

26.9 Withholding on Distributions from Retirement Plans and Commercial Annuities

Retirement plan and commercial annuity distributions are subject to withholding taxes, but you may choose to avoid withholdings. The method of avoiding withholding varies with the type of payment.

Periodic payments. If you receive periodic payments from a pension or an annuity (employee annuity or commercial annuity) in regular installments over more than one year (installments could be monthly, quarterly, semi-annually, or annually), withholding is required unless you elect to avoid withholding on Form W-4P, or on a substitute form furnished by the payer. If you are a U.S. citizen or resident alien, withholding may not be avoided on pensions or other distributions paid outside the U.S. or U.S. possessions. Payment must be to your home address within the U.S. (or in a U.S. possession) to avoid withholding.

The payer of a pension or annuity will use the regular wage withholding tables to figure withholdings on periodic payments as if you were married and claiming three withholding exemptions, unless on Form W-4P you elect to avoid withholding or you claim a different number of allowances and marital status. Withholding allowances may be claimed on Form W-4P for estimated itemized deductions, tax credits and adjustments to income such as alimony payments, student loan interest, and deductible IRA contributions.

You cannot designate the specific dollar amount that you would like to have withheld, but after selecting the number of withholding allowances and marital status on Form W-4P, you may request that the payer withhold a specific amount of additional tax from each payment.

Nonperiodic payments. Nonperiodic payments that are not eligible eligible rollover distributions (see the next paragraph) are subject to withholding at a flat 10% rate unless you elect to avoid withholding on Form W-4P (or substitute form). IRA distributions that are payable upon demand are considered nonperiodic and, thus, subject to the 10% withholding rule. If you want more than 10% withheld, you can enter an additional amount on Form W-4P. As with periodic distributions (see above), the election to avoid withholding cannot be made for a nonperiodic distribution if you are a U.S. citizen or resident alien and payment is made to you outside the United States or its possessions.

Eligible rollover distributions from qualified employer plans. Employers must withhold 20% from nonperiodic payments, such as lump-sum distributions, that are eligible for tax-free rollover but which are paid directly to you. To avoid withholding you must direct your employer to make a direct rollover (7.6) of the funds to an IRA or to a qualified plan of your new employer. If you do not instruct your employer to make the direct transfer and elect to personally receive the distribution, 20% will be withheld before payment is made to you. The 20% withholding rule does not apply to qualifying hardship distributions or payments that are part of a series of substantially equal payments, as these are not eligible for rollover (7.5).

See 7.6 for a further explanation and the “John Anderson” example showing the effects of the withholding rule where you receive the distribution and then decide to make a rollover yourself.

26.10 Backup Withholding

Backup withholding is designed to pressure taxpayers to report interest and dividend income. You may be subject to backup withholding if you do not give your taxpayer identification number to parties paying you interest or dividend income, you give an incorrect number, or you ignore IRS notices stating that you have underreported interest or dividends. Your taxpayer identification number generally is your Social Security number or your employer identification number. The backup withholding rate is 28%.

Backup withholding will apply to fees of $600 or more (Form 1099-MISC) for work you do as an independent contractor, payments from brokers (Form 1099-B), royalty payments (Form 1099-MISC), and certain gambling winnings (26.7) if you do not give the payer your taxpayer identification number.

If you provide false information to avoid backup withholding, you could face a civil penalty of $500 or, if convicted of a willful violation, a criminal penalty of up to a $1,000 fine or imprisonment of up to one year or both.