What Is Courtesy Withholding and How Does It Work?

Employers sometimes withhold state or local taxes from an employee’s paycheck even when not legally required. This is known as courtesy withholding and helps employees meet tax obligations in a different jurisdiction than their employer’s location. While beneficial, it requires coordination to ensure accuracy and compliance.

Understanding how courtesy withholding works can prevent unexpected tax liabilities.

Common Reasons for Courtesy Withholding

Employees who live in a different state or locality than where they work often face tax obligations in their home jurisdiction. Some states, such as Pennsylvania and Indiana, have reciprocal agreements allowing residents to pay income tax only in their home state. When no such agreement exists, individuals may owe taxes in both locations. Courtesy withholding allows employers to deduct taxes for the employee’s resident state, reducing the need for estimated tax payments and minimizing underpayment penalties.

Remote work has made this practice more relevant. Employees working from states where their employer has no tax presence may need to make quarterly estimated payments to avoid penalties. For example, New York requires residents to pay state income tax regardless of where they work. A remote employee living in New York but working for a Florida-based company—a state with no income tax—would still owe New York taxes. If the employer voluntarily withholds New York taxes, it simplifies compliance for the employee.

Local tax obligations also matter. Cities like Philadelphia and St. Louis impose local income taxes that residents must pay even if they work elsewhere. Without courtesy withholding, employees must track and remit these taxes themselves. Some employers offer this service to attract talent from high-tax areas, making tax management easier for employees.

Eligibility and Documentation

Before implementing courtesy withholding, employers must determine whether their payroll system can process deductions for a jurisdiction where they have no legal obligation to withhold taxes. Some payroll providers support multi-state or local tax withholding, while others require manual adjustments. Employers also need to verify whether the state or locality allows voluntary withholding. For example, California does not require withholding for nonresident employees unless the employer has a tax presence in the state but allows voluntary participation if both parties agree.

Once an employer confirms they can process courtesy withholding, employees must provide documentation to authorize deductions. This often includes state-specific withholding forms, such as New York’s IT-2104.1 for voluntary withholding or Ohio’s IT 4NR for nonresidents requesting adjustments. Some localities, like those in Pennsylvania, require residency affidavits or municipal tax forms. Employers may also request proof of residency, such as a driver’s license or utility bill.

Maintaining accurate records is essential. Employers should retain authorization forms and supporting documentation in case of an audit. Employees should review their pay stubs periodically to confirm the correct withholding amount, as errors can lead to unexpected tax liabilities.

Requesting or Cancelling Arrangements

Employees requesting courtesy withholding must submit a formal request, typically completing a voluntary withholding form from the state or local tax authority. Some employers may also require an internal payroll form. Since tax rates and filing requirements differ by location, employees should calculate an appropriate withholding amount to avoid overpaying or underpaying.

Employers must verify that their payroll system can accommodate the deduction. Some states, such as Arizona, allow employees to specify a fixed dollar amount rather than a percentage of wages, which can affect payroll processing. Additionally, payroll deadlines may impact when changes take effect. If an employee submits a request mid-pay cycle, the adjustment may not be reflected until the next payroll period.

Circumstances may change, requiring an employee to cancel or modify their courtesy withholding arrangement. A job relocation, change in residency, or shift to self-employment could make voluntary withholding unnecessary. To cancel, employees typically need to submit a written request or an updated withholding form. Some states require a specific form, while others allow changes through an employer’s payroll system. Employers should communicate deadlines for submitting cancellation requests to ensure timely processing.

Reconciling Tax Liabilities

Even with courtesy withholding, employees must ensure the correct amount has been deducted throughout the year to avoid unexpected tax bills. Differences in state tax rates, deductions, and credits can result in discrepancies, especially when an employer withholds based on estimates rather than actual liability. Employees should compare their year-to-date withholdings on pay stubs with projected tax obligations using state tax tables and online calculators. If withholding falls short, adjusting contributions before year-end can prevent underpayment penalties, which in some states, such as California, accrue at an annual rate of 7%.

Tax reconciliation also involves employer payroll reporting. Employers must correctly allocate withheld amounts on W-2 forms, particularly in Box 17 (State Income Tax) and Box 19 (Local Income Tax). Errors in reporting can lead to mismatches when employees file their state returns, potentially triggering audits or delays in refunds. If an employer incorrectly reports courtesy withholding under the wrong state code, employees may need to file amended returns or request a corrected W-2 (Form W-2c), extending tax filing timelines.

Different Jurisdiction Considerations

Tax laws vary significantly between states and localities, affecting how courtesy withholding is handled. Some jurisdictions encourage voluntary withholding, while others impose restrictions or require additional compliance measures. Employers and employees must be aware of these differences to ensure proper tax reporting.

Certain states, such as New Jersey, allow employers to register for withholding even if they have no physical presence in the state, making it easier for employees to meet tax obligations. In contrast, states like Texas and Florida, which do not levy state income tax, have no withholding requirements, meaning employees working remotely from these states may not need courtesy withholding at all. Additionally, some localities, such as New York City, impose income taxes separate from state taxes, requiring employers to withhold for multiple jurisdictions if an employee resides in one and works in another.

Reciprocity agreements further complicate withholding decisions. While states like Virginia and Maryland allow residents to be taxed only in their home state, others, such as California and Oregon, do not, leading to potential double taxation if courtesy withholding is not properly managed. Employees working across multiple states may need to file nonresident returns to claim credits for taxes paid elsewhere. Employers should consult state revenue departments or tax professionals to determine the best approach for handling multi-jurisdictional withholding.