Most governments throughout the world require citizens to pay income taxes in one form or another. Within the United States, taxpayers must pay income tax either through income tax withholding or by paying estimated taxes. For those who use the income tax withholding system, the employer withholds a certain percentage of money from each paycheck and transmits the funds to the Internal Revenue Service (IRS) on behalf of the taxpayer. The amount the employer holds back depends on the figure the employee used for his or her withholding tax exemption on his or her IRS Form W-4.
In the United States, taxpayers whose income is below a certain threshold, which is subject to change each year, are entitled to at least one withholding tax exemption. The withholding tax exemption is a dollar amount that is exempt from taxation. In addition to the withholding tax exemption that a taxpayer may claim for himself or herself, a taxpayer may also be entitled to claim a withholding tax exemption for his or her spouse as well as any qualified dependents.
An exemption is an amount which is deducted "off the top," so to speak. A taxpayer figures his or her gross income and then may deduct the appropriate amount for each exemption to which he or she is entitled, leaving the adjusted gross income for the tax year. Exemptions should not be confused with deductions. A deduction is an amount that is subtracted after the taxable income is calculated. In the United States, a taxpayer may choose to use the standard deduction amount, or may itemize deductions, after the adjusted gross income is calculated.
For most workers, the withholding system is used to pay taxes throughout the year. Estimated taxes are usually only paid by self-employed individuals or businesses. An employer is required to have a new hire complete the IRS Form W-4 when hired. The IRS Form W-4 tells the employer how many withholding tax exemptions the employee is claiming for the year. Based on the number of exemptions claimed, and the amount of the employee's pay, the employer determines how much must be withheld and forwarded to the IRS each pay period.
At the end of the year, each taxpayer will receive an IRS Form W-2, which indicates how much he or she earned and how much was withheld by the employer on his or her behalf. The employee will then complete his or her tax return and reconcile the figures to see if he or she still owes taxes or is due a refund. When the proper withholding tax exemption figure is used, an employee should not owe taxes at the end of the year.