Withholding

What Is Withholding?

Withholding is the practice of subtracting tax from income at the moment it is paid, so the money reaches the government before it reaches the recipient. The party making the payment, such as an employer, bank, or brokerage, keeps back a portion of the amount and forwards it to the tax authority on the recipient's behalf. The most familiar example is the amount removed from each paycheck for income tax, which is why take-home pay is usually smaller than gross wages. Withholding also applies to certain interest and dividend payments, retirement account distributions, and payments made to people or businesses abroad.

How It Works

Withholding is designed to collect tax gradually across the year rather than in one lump sum. An employer estimates how much income tax an employee is likely to owe, based on pay and on information the employee provides on a withholding form, and subtracts that estimate from every paycheck. The employer reports the totals to the government and gives the employee a summary at year end. When the amount withheld is compared with the tax actually owed, the result is either a balance due or a tax refund.

In the United States, certain investment payments may be subject to backup withholding if the recipient has not supplied a correct taxpayer identification number. Some countries also withhold tax on income paid to non-residents, often at a rate set by domestic law or by a tax treaty between countries.

Why It Matters to Investors

Investors encounter withholding mainly through dividends, interest, and foreign investments. Tax withheld on foreign dividends reduces the cash received, although it may be claimed as a credit against tax owed at home, depending on the rules of the investor's country. Withholding that is too low can lead to an unexpected bill at tax time. This is why people with significant income outside of wages, such as investment gains or self-employment earnings, often make estimated tax payments directly to the government during the year.