Annual Compensation

• The most important factor that determines how much federal tax your employer will withhold from your paycheck is the amount of your annual taxable compensation. The more money you earn, the more tax you must pay. In addition, as your income increases, so do the tax rates that apply to the higher portions of your income. However, your taxable compensation includes more than just the cash salary you receive. It also includes the tuition reimbursements that aren't part of a qualified reimbursement plan, certain types of insurance coverage your employer provides you with and the payment of sick or vacation time you never use.
  
  

Allowances on W-4

• You do have some control over how much your employer will withhold each payroll period by filling out a W-4, which attempts to estimate your annual income tax bill after considering your filing status, the number of exemptions you anticipate claiming and the deductions and credits you will report at the end of the year. The form uses an allowance system to calculate your withholding. For example, increasing your allowances by one for each dependent you claim on your return is common. Since the dependent exemption reduces your taxable income by a fixed amount, the increase in allowances reduces your withholding.
  
  

Social Security and Medicare

• You must pay other federal taxes in addition to the income tax for which the government requires your employer to withhold part of your wages. Every taxpayer must contribute to the Social Security and Medicare programs by paying a tax. The Social Security tax is equal to 6.2 percent of the first $106,800 of wages you earn. However, in 2011 the government has temporarily reduced the rate to 4.2 percent, but only for one year. In addition, you are responsible for paying 1.45 percent of your entire earnings to the Medicare system. Both taxes come directly out of your paycheck, and you cannot reduce the withholding amount for allowances.
  
  

Withholding Penalties

• To deter taxpayers from claiming allowances on the W-4 form with no reasonable basis for doing so, the IRS will impose tax penalties on you if there is insufficient withholding. As of 2011, the penalty is equal to $500. And if your W-4 reporting rises to the level of fraud, you may be subject to criminal sanctions as well as an additional $1,000 fine.