Have you heard of withholding but aren’t sure what it means? Bankrate explains.

What is withholding?

Withholding is when an employer deducts money from an employee’s wages and uses it to prepay government tax charges on the annual income of the employee. A taxpayer who underestimates the withholding tax required to meet obligations may have to pay a penalty for underpayment.

Deeper definition

The Internal Revenue Service (IRS) requires withholding from certain forms of compensation paid by employers to employees. The amount of income tax an individual owes is determined upon filing a tax return at the end of the fiscal year. The funds withheld and paid by the employer to the IRS are applied as a prepayment of income tax and are refundable if they exceed the taxpayer’s liability.

When an individual is hired for a job, she must complete a federal W-4 Form, which permits her employer to retain a certain amount of her earnings to be paid to the government to meet federal income tax liability. The employee estimates income, credits, deductions, and exemptions to find out how many withholding allowances she can claim. The more allowances claimed, the less tax is taken out each payment period.

Withholding prevents taxpayers from being blindsided by large tax bills. By having employers withhold portions of their employees salaries, the government also guarantees steady cash flow throughout the year and lessens the risk of employees failing to pay their tax liabilities. An individual’s tax liability may still be more or less than what she pays in withholding taxes each year. This means that the taxpayer may need to pay more tax when filing or may get a tax refund.

Withholding example

The U.S. federal income tax system is a “pay-as-you-go” system that requires wage earners to pay federal tax as they generate income. For example, Katrina Kurt’s salary is $30,000 per year. Although she makes $2,500 per month, she only takes home $2,000, as her employer deducts $500 from her salary and remits it to the government on her behalf. The payments go to Katrina Kurt’s state income tax, federal income tax, unemployment, and Medicare liabilities.

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