Withholding Your Taxes

Your employer is required to withhold federal income (FIT) and FICA taxes from your salary or wages. FICA taxes include payments for Social Security and Medicare.

For 2008, your employer withholds Social Security at the rate of 7.65% of your first $102,200 of income. For Medicare, the withholding rate is 1.45% of your income, regardless of how much you earn.

These taxes are collected to pay for the federal government's benefits programs.

The number of allowances you claim when you complete IRS Form W-4, together with any additional dollar amount you want withheld by your employer, determines the rate at which your employer withholds your federal income taxes.

A worksheet at the top of the W-4 helps you to calculate the number of allowances you can take. Total allowances also depend on your tax filing status and tax credits.

If you have a second job, are married and both spouses work, and have a combined income from all jobs exceeding $40,000, or plan to itemize your deductions, you also complete a short worksheet on the W-4 to determine any additional allowances or withholdings.

You must complete a W-4 whenever you start a new job. You should also update your withholding when you have a change in your circumstances, including:

A change in marital status, number of dependents or name.

A change in income from sources other than wages or salary.
Certain changes in wage and salary income for you or a spouse, including a second job, losing a job or changing jobs.

A change in the amount of deductions that you itemize.

You can submit a new W-4 with your employer at any time. You can also change your withholding amount by either changing your number of allowances or the additional amount that you wish to have withheld. For additional information, see IRS Pub. 919.

Another case in which you may face a mandatory withholding by your employer: Rolling over your retirement plan when you retire or change jobs. Under IRS rules, your employer must withhold 20% if you handle the money. This kind of transaction is called an indirect rollover. In general, using a direct rollover spares you from this withholding. You may wish to seek the advice of a professional financial or tax adviser on the options for rolling over a retirement plan.

Ideally, the amount of income taxes you have withheld from your income is equal, or close to equal, the amount of taxes you will owe for the year. If too much is withheld, a refund may be appealing but remember that a refund has a hidden opportunity cost: Instead of you earning interest on your income, you're making an interest-free loan to the IRS!

On the other hand, if too little is withheld and you're not prepared to pay at tax time, you may be forced to draw on your savings or, worse, pay with a credit card. To the extent possible, you want to optimize your withholdings to equal your estimated tax liability.

In addition, the IRS may penalize you if you have too little withheld. You're required to pay at least 90% of your estimated tax liability for the year by Jan. 15. That gives you two weeks from the end of the tax year to calculate your tax liability and check your Form W-2 to make sure you're on target. If you've withheld too little, you must complete Form 2210.

For additional information on withholding, see IRS Pub. 505.