If you earn an income, you have to pay federal income taxes. Most people fall into one of two categories — those who pay taxes by having it withheld from their paychecks and those who pay quarterly estimated taxes out-of-pocket.

Depending on where you live, you also may have to pay state income taxes. State taxes usual work similarly to federal taxes, but there are some exceptions.

What is withholding?

If you receive regular paychecks from an employer, income taxes — federal, state, local — and Social Security and Medicare taxes are paid automatically throughout the year through a process called withholding.

When you start a new job, you’ll fill out a Form W-4. The information you put on this form determines the amount your employer will withhold from your paycheck for these taxes. The employer sends this money to the Internal Revenue Service (IRS) and, if you live in a state that requires income taxes, the taxing authority in your state.

When you file taxes, you’ll compare what you’ve paid throughout the year with what you owe. If you paid too much, you’ll get a refund. If you paid too little, you’ll have to pay the difference when you file your return.

• See also: Income tax returns, Deductions, exemptions and credits

Your monthly pay stubs tell you how much you’ve earned and how much has been withheld in taxes. Your employer or employers also are required to send you a Form W-2 no later than January 31 for any income you earned from them the previous year. This form is a summary of the income you earned that year and all the amounts the employer withheld for taxes. Always compare your W-2 to your pay stubs to be sure that the reported amounts are accurate.

• See also: Paychecks, Income tax returns

Why is withholding important?

Withholding is required because income tax in the United States is a "pay as you go" system. You need to pay taxes throughout the year, as you earn income, not all at once when you file your income tax return. If you get a refund, your withholding was too high — and it says nothing about whether your tax planning was good or bad. It’s a delicate balancing act to make sure you don’t have too much or too little of your salary withheld.

Withholding is a delicate balancing act to make sure you don’t have too much or too little of your salary withheld.

Your goal is to minimize your end-of-year refund, without owing any tax at the end of the tax year — don’t pay too much or too little.

If you get a big refund at the end of the tax year, you’ve essentially given the federal government your own money as a tax-free loan throughout the year — rather than using it on retirement savings or as part of your budget. If too little is withheld, you will have a large tax bill to pay at the end of the year. If it’s big enough, you can be hit with penalties when you file your tax return.

How to calculate withholding?

The Form W-4 includes a simple worksheet to help you calculate your personal allowances. A few rules about allowances:

• They reduce the amount of tax withheld from your paycheck

• The more you claim, the less tax you will have withheld

• Claiming more does not decrease the tax you owe, just the tax payments you make throughout the year

• If you have too little withheld, you will have a large tax bill to pay at the end of the year.

• IRS Withholding calculator: www.irs.gov/individuals/page/0,,id=14806,00.html

If you qualify, you may claim exempt status. This status applies only to people who will not earn enough that year to owe any federal income. If you qualify, simply write the word “exempt” on the Form W-4. No money will be withheld from your paycheck for federal income taxes.

The law changes every year on who can claim exemptions, so check the IRS website:

• IRS Exemptions: www.irs.gov/publications/p501/ar02.html#en_US_2010_publink1000220844

• See also: Income tax returns

Your total number of allowances is based on whether you:

• File your taxes individually or jointly (with a spouse)

• Itemize deductions

• Work more than one job

• Qualify for credits

• Have dependents

• Have sources of income other than your job

Most people should aim for a number of allowances that will result in at least the prior year’s tax payment being withheld — unless you’ve switched jobs or have a dramatically different salary. Usually that means claiming one allowance each for you, your spouse and each dependent. But if you have major deductions to take advantage of — such as a large mortgage — you may want to boost your allowances so that less money is siphoned off from your paycheck.

• See also: Deductions, exemptions and credits

Your allowances can get complicated if you have other sources of income, including a working spouse, if you receive large bonuses, if you have a lot of deductions or credits, or if you have other factors that complicate your tax returns. Consider talking with a tax professional to make sure you are filing correctly.

• See also: Tax professionals

The IRS has a withholding calculator to help you figure out some of these complicated issues. So gather together your recent pay stubs and last year’s tax return and go through the online questionnaire.

• IRS Withholding calculator: www.irs.gov/individuals/page/0,,id=14806,00.html

Of course, if it turns out you’re off in your calculations, don’t fret: You can change your withholding during the year if needed by filling out new Form W-4. People do it all the time if they’ve gotten married, had a kid, or bought a house. So just check your withholding occasionally, make sure you’re on target for your end-of-year tax bill and relax that you’ve finally figured out at least one crucial element of the tax code.

What are estimated taxes?

In addition to paying taxes through paycheck withholding, anyone can make quarterly estimated tax payments. You can pay estimated taxes throughout the year to pay tax on income that is not subject to withholding. This includes income from self-employment, investments, rent, gains from the sale of assets and more. You also may have to pay estimated tax if the amount of income tax being withheld from your salary is not enough.

Why do you need to pay estimated taxes?

Estimated tax is used to pay income tax and self-employment tax, as well as other taxes and amounts reported on your tax return. If you do not pay enough through withholding or estimated tax payments, you may be charged a penalty. If you do not pay enough by the due date of each payment period you may be charged a penalty even if you are due a refund when you file your tax return.

When to pay estimated taxes?

Estimated taxes payments are due on four quarterly due-dates: April 15, June 15, September 15 and January 15 (for the prior year). These dates can shift a day or two later if the 15th falls on a holiday, but otherwise are the same each year. By sending in tax payments at these dates, you'll fulfill your obligation to "pay as you go" and avoid penalties that you might owe if you only paid your taxes when you filed your tax return.

If you did not pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. In general, you can avoid this penalty if you:

• Owe less than $1,000 in tax after subtracting withholding and credits
• Paid at least 90% of the tax amount for the current year or 100% of the tax shown on last year’s return — whichever amount is smaller. The percentages are higher if your income is high.

If you’re self-employed and paying quarterly estimated taxes, we recommend you work with a tax professional to make sure you’re paying and filing correctly.

• See also: Tax professionals

How to pay estimated taxes

It's easy to end up with a very large tax bill if you don't keep an eye on your estimated taxes. A common problem for self-employed people in their first year is not keeping track of taxes that are due — especially forgetting about the self-employment tax. So if you're self-employed, be sure to check in every month to see how you're doing and hold back enough cash in your checking account to cover quarterly estimated tax payments.

Paying estimated taxes can be a bit complicated, because you need to do a "mini tax return," to predict how much tax you're going to owe for the year. Based on rules about the minimum you need to pay in advance to avoid penalties, you:

• Come up with an estimate of what you’re going to earn that year

• Come up with an estimate of what you have to pay in taxes on that income

• Divide that figure by four, and send in that amount each quarter by the estimated-tax due date.

You use federal Form 1040-ES to figure out how much to send, and mail each quarterly check with a voucher that is part of that form. The voucher lets the IRS know that you're making an estimated tax payment, so your Social Security number is credited properly.

You also can use Form 1040 ES to mail each quarterly check with a voucher that’s part of the form. Or you can pay federal taxes electronically using the Electronic Federal Tax Payment System (EFTPS), which is a free service from the U.S. Department of the Treasury.

• EFTPS: www.eftps.gov

Payments must be scheduled at least one calendar day prior to the tax due date by 8:00 p.m. ET. Your payment instruction will be executed on the date you selected, and your records will be updated at the IRS.

This service is only for federal taxes. You have to pay state taxes directly through your state tax authority — check your state website to see how you make estimated tax payments on income tax. State rules vary.

• See also: Self-employment

If you’re unsure if you’re making payments correctly, consider working with a tax professional.

• See also: Tax professionals, Income tax returns

Words to know

Unsure about something you read? Many of the financial terms you came across in this article are defined in our financial glossary. A-Z Glossary

Links we like

Here are a couple online features you might find useful:

• Publication 505: Tax withholding and estimated tax: www.irs.gov/publications/p505/index.html

• Self-employed Individuals tax center: www.irs.gov/businesses/small/selfemployed/index.html