Introduction

The federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year. There are two ways to pay as you go.

• Withholding. If you are an employee, your employer probably withholds income tax from your pay. Tax may also be withheld from certain other income - including pensions, bonuses, commissions, and gambling winnings. In each case, the amount withheld is paid to the Internal Revenue Service (IRS) in your name.
• Estimated tax. If you do not pay your tax through withholding, or do not pay enough tax that way, you might have to pay estimated tax. People who are in business for themselves generally will have to pay their tax this way. You may have to pay estimated tax if you receive income such as dividends, interest, capital gains, rents, and royalties. Estimated tax is used to pay not only income tax, but self-employment tax and alternative minimum tax as well.

This publication explains both of these methods. It also explains how to take credit on your return for the tax that was withheld and for your estimated tax payments.

If you did not pay enough tax during the year either through withholding or by making estimated tax payments, you may have to pay a penalty. The IRS usually can figure this penalty for you. This underpayment penalty, and the exceptions to it, are discussed in chapter 4.

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Important Changes for 2001

You should consider the items in this section when figuring any underpayment penalty for 2001. Figuring the penalty is discussed in chapter 4.

Penalty rate.   The penalty for underpayment of 2001 estimated tax is figured at an annual rate of 8% for the number of days the underpayment remained unpaid from April 16, 2000, through June 30, 2001; 7% from July 1, 2001, through December 31, 2001; 6% from January 1, 2002, through April 15, 2002.

Estimated tax safe harbor for higher income individuals.   For installment payments for tax years beginning in 2001, the estimated tax safe harbor for higher income individuals (other than farmers and fishermen) has been modified. If your adjusted gross income was more than $150,000 ($75,000 if married filing a separate return), you must have deposited the smaller of 90% of your expected tax for 2001 or 110% of the tax shown on your 2000 return to avoid an estimated tax penalty.

Important Changes for 2002

You should consider the items in this section when you figure your estimated tax or how much income tax you want withheld from your pay for 2002. For more information on these and other tax changes, see Publication 553, Highlights of 2001 Tax Changes.

Estimated tax safe harbor for higher income individuals.   For installment payments for tax years beginning in 2002, the estimated tax safe harbor for higher income individuals (other than farmers and fishermen) has been modified. If your adjusted gross income is more than $150,000 ($75,000 if married filing a separate return), you will have to deposit the smaller of 90% of your expected tax for 2002 or 112% of the tax shown on your 2001 return to avoid an estimated tax penalty.

Certain withholding rates decreased.    The withholding rates on the following items have been decreased.

1. Gambling winnings. The rate has decreased from 28% to 27%.
2. Unemployment compensation. The rate has decreased from 15% to 10%.
3. Federal payments. Withholding on certain federal payments is voluntary. The elective rates have been decreased to 7%, 10%, 15%, and 27%.
4. Backup withholding. The rate has decreased from 31% to 30%.
5. Supplemental wages. The rate has decreased from 28% to 27%.

Withholding on these items is discussed in chapter 1.

Tax rates reduced.   For tax years beginning in 2002, the income tax rates have been reduced. The following items highlight these changes.

10% tax rate. The 10% tax rate is reflected in the tax tables and tax schedules. You do not have to make a separate computation or figure a credit to get the benefits of this rate.

Other tax rates. The other tax rates, 27.5%, 30.5%, 35.5%, and 39.1% are reduced to 27%, 30%, 35%, and 38.6%, respectively. These reduced rates should be reflected in amounts withheld (such as backup withholding) on certain payments made after 2001.

Earned income credit (EIC).   Significant changes to the EIC take effect in 2002.

• Earned income will no longer include nontaxable employee compensation.
• The EIC will be based, in part, on adjusted gross income (AGI), not modified AGI.
• New rules will be used to determine which person can claim a qualifying child when two or more persons may be able to claim the same child.
• The definition of an eligible foster child will change. The child will have to live with you for more than half of the year, instead of the whole year.
• The EIC will no longer be reduced by the amount of alternative minimum tax shown on your return.

Higher education expenses.   You may be able to deduct as an adjustment to income up to $3,000 of qualified tuition and related expenses you paid. The expenses can be for you, your spouse, or your dependent.

Interest on student loans.    Two changes apply to the deduction for student loan interest.

• The provision that limited your deduction to interest paid during the first 60 months is repealed.
• The modified AGI phaseout amounts are increased.

For more information on the deduction for student loan interest, see Publication 970.

Coverdell education savings accounts.   The following changes apply to Coverdell education savings accounts.

• Contribution limit increases to $2,000 per beneficiary.
• The income phase out increases for joint filers.
• Qualified education expenses include elementary and secondary school expenses.
• Age limits do not apply to special needs beneficiaries.
• Contributions may be made until April 15 of the following year.
• Tax-free distributions can be used for special needs services.

Employer-provided educational assistance.   The following changes apply to employer-provided educational assistance.

• The exclusion is made permanent.
• The exclusion applies to graduate level courses.

Qualified tuition programs.   The qualified tuition program (formerly qualified state tuition program) includes programs established and maintained by one or more eligible educational institutions. Two other changes affect this program.

• Distributions from a state program that are used to pay qualified higher education expenses are tax free. Other distributions are subject to 10% additional tax.
• Tax-free distributions can be used for special needs services.

Tax benefits for adoption.   Changes apply to the adoption credit and to the exclusion for benefits under an employer-provided adoption assistance program. These changes include the following.

• The credit for children without special needs is made permanent.
• The exclusion under an adoption assistance program is made permanent.
• The credit and exclusion amounts increased to a maximum of $10,000.
• The modified AGI phaseout amounts increased.

Benefits for public safety officer's survivors.   For tax years beginning after 2001, a survivor annuity received by the spouse, former spouse, or child of a public safety officer killed in the line of duty will generally be excluded from the recipient's income regardless of the date of the officer's death. Survivor benefits received before 2002 are excluded only if the officer died after 1996.

Foreign earned income exclusion.   The amount of foreign earned income that you can exclude will increase to $80,000. See Publication 54.

Self-employed health insurance deduction.   The part of your self-employed health insurance premiums that you can deduct as an adjustment to income increases to 70%.

Retirement savings plans.   The following paragraphs highlight changes that affect individual retirement arrangements (IRAs) and pension plans.

Increased IRA contribution and deduction limit. Your maximum contribution (and any allowable deduction) limit is increased. Previously, the limit was $2,000. The new limit depends on your age at the end of the year.

• If you are under age 50, the most you can contribute is the smaller of $3,000, or your taxable compensation.
• If you are age 50 or older, the most you can contribute is the smaller of $3,500, or your taxable compensation.

Rollovers of IRAs into qualified plans. For distributions after December 31, 2001, you may be able to roll over tax free, a distribution from your IRA into a qualified plan.

Rollovers of distributions from employer plans. For distributions after December 31, 2001, you can roll over both the taxable and nontaxable part of a distribution from a qualified plan into a traditional IRA.

Hardship exception to the 60-day rule. For distributions after December 31, 2001, the IRS may waive the 60-day requirement to roll over distributions from your IRA or your employer's pension plan where the failure to do so would be against equity or good conscience, including casualty, disaster, or other events beyond your reasonable control.

Limit on elective deferrals. The maximum amount of elective deferrals under a salary reduction agreement that can be contributed to a qualified plan is increased to $11,000 ($12,000 if you are age 50 or over). However, for SIMPLE plans, the amount is increased to $7,000 ($7,500 if you are age 50 or over).

New credit for elective deferrals and IRA contributions. You may be able to take a credit of up to $1,000 for qualified retirement savings contributions.

Meal expenses when subject to hours of service limits.   If you are subject to the Department of Transportation's hours of service limits, the percentage of your business-related meal expenses that you can deduct has increased. For 2002 and 2003, you can deduct 65% if the meals take place during or incident to the period subject to those limits.

Important Reminder

Photographs of missing children.   The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843- 5678) if you recognize a child.

Tax Withholding for 2002

Important Changes

Certain withholding rates decreased.    The withholding rates on the following items have been decreased.

1. Gambling winnings. The rate has decreased from 28% to 27%.
2. Unemployment compensation. The rate has decreased from 15% to 10%
3. Federal payments. Withholding on certain federal payments is voluntary. The elective rates have been decreased to 7%, 10%, 15%, and 27%.
4. Backup withholding. The rate has decreased from 31% to 30%.
5. Supplemental wages. The rate has decreased from 28% to 27%.

Introduction

This chapter discusses withholding on these types of income:

• Salaries and wages,
• Tips,
• Taxable fringe benefits,
• Sick pay,
• Pensions and annuities,
• Gambling winnings,
• Unemployment compensation, and
• Federal payments.

This chapter explains in detail the rules for withholding tax from each of these types of income. The discussion of salaries and wages includes an explanation of how to complete a Form W-4.

This chapter also covers backup withholding on interest, dividends, and other payments.

Useful Items You may want to see:

Publication

• 919   How Do I Adjust My Tax Withholding?

Form (and Instructions)

• W-4   Employee's Withholding Allowance Certificate
• W-4P   Withholding Certificate for Pension or Annuity Payments
• W-4S   Request for Federal Income Tax Withholding From Sick Pay
• W-4V   Voluntary Withholding Request

See chapter 5 of this publication for information about getting these publications and forms.

Salaries and Wages

Income tax is withheld from the pay of most employees. Your pay includes your regular pay, bonuses, commissions, and vacation allowances. It also includes reimbursements and other expense allowances paid under a nonaccountable plan. See Supplemental Wages, later, for more information about reimbursements and allowances paid under an accountable plan.

Military retirees.   Military retirement pay is treated in the same manner as regular pay for income tax withholding purposes, even though it is treated as a pension or annuity for other tax purposes.

Household workers.   If you are a household worker, you can ask your employer to withhold income tax from your pay. A household worker is an employee who performs household work in a private home, local college club, or local fraternity or sorority chapter.

Tax is withheld only if you want it withheld and your employer agrees to withhold it. If you do not have enough income tax withheld, you may have to make estimated tax payments, as discussed in chapter 2.

Farmworkers.   Income tax is generally withheld from your cash wages for work on a farm unless your employer both:

1. Pays you cash wages of less than $150 during the year, and
2. Has expenditures for agricultural labor totaling less than $2,500 during the year.

If you receive either noncash wages or cash wages not subject to withholding, you can ask your employer to withhold income tax. If your employer does not agree to withhold tax, or if not enough is withheld, you may have to make estimated tax payments, as discussed in chapter 2.

Determining Amount of Tax Withheld

The amount of income tax your employer withholds from your regular pay depends on two things.

1. The amount you earn.
2. The information you give your employer on Form W-4.

Form W-4 includes three types of information that your employer will use to figure your withholding.

1. Whether to withhold at the single rate or at the lower married rate.
2. How many withholding allowances you claim (each allowance reduces the amount withheld).
3. Whether you want an additional amount withheld.

If your income is low enough that you will not have to pay income tax for the year, you may be exempt from withholding. This is explained under Exemption From Withholding, later.

Note.   You must specify a filing status and a number of withholding allowances on Form W-4. You cannot specify only a dollar amount of withholding.

New job.   When you start a new job, you must fill out a Form W-4 and give it to your employer. Your employer should have copies of the form. If you need to change the information, you must fill out a new form.

If you work only part of the year (for example, you start working after the beginning of the year), too much tax may be withheld. You may be able to avoid overwithholding if your employer agrees to use the part-year method, explained later.

Changing your withholding.   Events during the year may change your marital status or the exemptions, adjustments, deductions, or credits you expect to claim on your return. When this happens, you may need to give your employer a new Form W-4 to change your withholding status or number of allowances.

You must give your employer a new Form W-4 within 10 days after either of the following.

1. Your divorce, if you have been claiming married status.
2. Any event that decreases the number of withholding allowances you can claim.

Events that will decrease the number of withholding allowances you can claim include the following.

1. You have been claiming an allowance for your spouse, but you get divorced or your spouse begins claiming his or her own allowance on a separate Form W-4.
2. You have been claiming an allowance for a dependent, but you no longer expect to provide more than half the dependent's support for the year.
3. You have been claiming an allowance for your child, but you now find that he or she will earn more than $3,000 during the year. In addition, he or she will be:
   1. 24 or older by the end of the year, or
   2. 19 or older by the end of the year and will not qualify as a student.
4. You have been claiming allowances for your expected deductions, but you now find that they will be less than you expected.

Generally, you can submit a new Form W-4 whenever you wish to change the number of your withholding allowances for any other reason.

If you change the number of your withholding allowances, you can request that your employer withhold using the cumulative wage method, explained later.

Changing your withholding for 2003.   If events in 2002 will decrease the number of your withholding allowances for 2003, you must give your employer a new Form W-4 by December 1, 2002. If an event occurs in December 2002, submit a new Form W-4 within 10 days. Events that will decrease the number of your allowances include the following.

• You claimed allowances for 2002 based on child care expenses, moving expenses, or large medical expenses, but you will not have these expenses in 2003.
• You have been claiming an allowance for your spouse, but he or she died in 2002.

Note.    Because you can still file a joint return for 2002, your spouse's death will not affect the number of your withholding allowances until 2003. You will also have to change from married to single status for 2003, unless you can file as a qualifying widow or widower because you have a dependent child, or you remarry.

You must file a new Form W-4 showing single status by December 1 of the last year you are eligible to file as qualifying widow or widower.

Part-year method.   If you work only part of the year and your employer agrees to use the part-year withholding method, less tax will be withheld from each wage payment than would be withheld if you worked all year. To be eligible for the part-year method, you must meet both the following requirements.

1. You must use the calendar year (the 12 months from January 1 through December 31) as your tax year. You cannot use a fiscal year.
2. You must not expect to be employed for more than 245 days during the year. To figure this limit, count all calendar days that you are employed (including weekends, vacations, and sick days) beginning the first day you are on the job for pay and ending your last day of work. If you are temporarily laid off for 30 days or less, count those days too. If you are laid off for more than 30 days, do not count those days. You will not meet this requirement if you begin working before May 1 and expect to work for the rest of the year.

How to apply for the part-year method.   You must ask in writing that your employer use this method. The request must state all three of the following.

1. The date of your last day of work for any prior employer during the current calendar year.
2. That you do not expect to be employed more than 245 days during the current calendar year.
3. That you use the calendar year as your tax year.

Cumulative wage method.   If you change the number of your withholding allowances during the year, too much or too little tax may have been withheld for the period before you made the change. You may be able to compensate for this if your employer agrees to use the cumulative wage withholding method for the rest of the year. You must ask in writing that your employer use this method.

To be eligible, you must have been paid for the same kind of payroll period (weekly, biweekly, etc.) since the beginning of the year.

Checking your withholding.   After you have given your employer a Form W-4, you can check to see whether the amount of tax withheld from your pay is too little or too much. See Getting the Right Amount of Tax Withheld, later. If too much or too little tax is being withheld, you should give your employer a new Form W-4 to change your withholding.

Note.   You cannot give your employer either a payment to cover withholding for past pay periods or a payment for estimated tax.

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