The Internal Revenue Service calls federal income tax a pay-as-you-go tax. If you are an employee, you pay it via paycheck withholding: your employer withholds it from your paycheck. If you are self-employed, you might be required to make estimated tax payments to the IRS. Federal income tax is based on a percentage of your income after qualifying deductions are subtracted from your gross earnings, known as taxable or adjusted gross income.
If you have an employer, it withholds federal income tax automatically from your paychecks based on your W-4 data and IRS Circular E’s withholding tax tables. The precise amount depends on your filing status and allowances (as per your W-4) and the Circular E tax table relevant to your filing status, allowances, taxable income and pay period.
Individuals who receive income not subject to tax withholding, such as interest, dividends or income from self-employment, make estimated tax payments if they meet IRS requirements. In 2011, you make estimated tax payments if you think you will owe no less than $1,000 for 2011 after you deduct your withholding and refundable credits. The tax rates are based on the tax tables in IRS Publication 505.
Each allowance you claim on your W-4 gives you an amount that reduces your taxable wages. To arrive at your withholding percentage, your employer subtracts your allowance sum from your taxable gross wages – your pay after any pretax deductions, such as 401(k) and Section 125 medical and dental benefits are subtracted. See page 35 of the 2011 IRS Circular E to determine the amount per allowance based on your pay period. Your employer uses the percentage method table (see page 36) that matches your filing status, pay period and wages after allowances are deducted to arrive at the withholding percentage.
If you are an employee, and all of your wages are subject to tax withholding, you do not make estimated tax payments. If you are self-employed or have income that requires you to make estimated tax payments, use the IRS tax rate schedule (see page 34 of IRS Publication 505) that pertains to your filing status and adjusted gross income. For example, if you claim single in 2011, and your adjusted gross income is not more than $8,500, you pay 10 percent of your adjusted gross income; if your income is more than $8,500 but not more than $34,500, you pay $850 plus $15 percent of income over $8,500.
You can use your prior year’s tax return (Form 1040) to help you figure out your expected adjusted gross income for the present year or IRS Publication 505. Unlike an employee whose employer makes her tax withholding payments to the IRS, a self-employed person makes her own estimated tax payments directly to the IRS in four equal payments throughout the year or in a lump sum payment by the tax-filing deadline – April 18 in 2011.