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What is withholding tax?

        Money | Taxes

Filling out the W-4 form correctly is very important to make sure the right amount of money is withheld from your paycheck for taxes.
Jeffrey Hamilton/Getty Images

When you start a new job, reams of paperwork are often waiting. One of the most crucial documents, the W-4 form, determines the amount of income tax withheld from each paycheck. You pay taxes on salaries, bonuses, commissions and allowances for vacations and expenses. If you figure your withholding tax correctly, the amount you pay is close to the amount you owe when you file your tax returns. However, if your withholding tax is incorrect, you might unhappily find yourself paying more money to the IRS.

Fortunately, you don't need a crystal ball to know how much of your compensation to withhold. The IRS provides employers with W-4 forms. On this document, you indicate if you want the withholding done at the single or married rate. You also specify how many allowances you're claiming and how much extra money you want withheld, if any. Allowances are based on marital status, the number of jobs you and your spouse have and your number of dependents. Your employer takes this information and, according to your salary, establishes how much will be deducted, starting with your very first paycheck.

W-4 forms are not just for new employees. Perhaps you get married or divorced, start moonlighting, or have a new addition to your family. You want your withholding tax to reflect those changes, so you'd file a revised W-4 form to make modifications. If too little tax is withheld, you'll pay in April. If too much is kept back you'll get a refund, but the federal government -- not you -- has been making interest off of that money.

But wait: There's more! Withholding tax is not limited to the IRS. More than half the states and the District of Columbia require employees to submit forms that determine their state taxes. While many states have unique withholding forms, some condense the process and simply use the W-4.

While both federal and state withholding tax forms are helpful, they are not infallible. Under some conditions, the system can fail, and the withheld amount is incorrect. You're at risk if you have two or more jobs, both you and your spouse are employed, you owe self-employment tax or you have additional income besides your salary. Fortunately, the IRS publishes "How Do I Adjust My Tax Withholding?" so you can see if you're on the right track [source: Internal Revenue Service]. If you pay the proper amount throughout the year, you don't end up having to fork out unexpected money at tax time, and the IRS doesn't have to bothering collecting more.