How to Calculate Withholding and Deductions from Employee Paychecks

Are you considering doing your own payroll processing? Calculating withholding and deductions for employee paychecks isn't difficult if you follow the steps detailed here. 

Your goal in this process is to get from the gross pay amount (gross pay is the actual amount you owe the employee) to net pay (the amount of the employee's paycheck). After you have calculated gross pay for the pay period, you must then deduct or withhold amounts for federal income tax withholding, FICA (Social Security/Medicare) tax, state and local income tax, and other deductions.

Step One: Get a W-4 Form From Each Employee

The IRS requires that all workers in the U.S. sign IRS Form W-4​ at hire. This form includes important information you will need to pay the employee and to make sure withholding and deductions are correctly calculated on the employee's pay. 

In addition to the employee's name and address, marital status, and filing status, you will need to get other information from the W-4 to do the withholding calculations for federal income tax. 

IRS Form W-4 has been changed effective January 1, 2020. This form is used to record employee information for calculating withholding and deductions. Be sure you are using the correct form, titled "Employee's Withholding Certificate" with "2020" in the upper right. This article on the new W-4 form has information on how to use the form for calculating withholding and deductions.

Step Two: Calculate Gross Pay

Employee paychecks start out as gross pay. Gross pay is the total amount of pay before any deductions or withholding. For the purpose of determining income tax and FICA tax (for Social Security and Medicare), use all wages, salaries, and tips. 

How to Determine Gross Pay

For salaried employees, start with the person's annual amount divided by the number of pay periods. For hourly employees, it's the number of hours worked times the rate (including overtime).

If you are not sure how to pay employees, read this article on the difference between salaried and hourly employees.

Here are examples of how gross pay for one payroll period is calculated for both salaried and hourly employees if no overtime is included for that pay period: 

A salaried employee is paid an annual salary. Let's say the annual salary is $30,000. That annual salary is divided by the number of pay periods in the year to get the gross pay for one pay period. If you pay salaried employees twice a month, there are 24 pay periods in the year, and the gross pay for one pay period is $1,250 ($30,000 divided by 24). 

An hourly employee is paid at an hourly rate for the pay period. If an employee's hourly rate is $12 and they worked 38 hours in the pay period, the employee's gross pay for that paycheck is $456.00 ($12 x 38).

Then include any overtime pay. Next, you will need to calculate overtime for hourly workers and some salaried workers. Overtime pay must be added to regular pay to get gross pay. 

Step Three: Calculate Overtime

All hourly employees are entitled to overtime if they work over 40 hours in a week. Some salaried employees are exempt from overtime, depending on their pay level. Lower-paid salaried employees must receive overtime if their salary is equal to or less than $455 a week ($23,660 annually), even if they are classified as exempt. 

You can pay more than the required overtime rate, but here we'll use the required amount. Some states also have overtime laws that require that overtime ​is to be paid at higher rates. Check your state labor department for details. 

Here's an example of how overtime is calculated: 

Sandy works 43 hours in one week. She is entitled to overtime for 3 hours at 1.5 times her hourly rate. If her hourly rate is $12, she receives overtime at the rate of $18 for 3 hours, totaling $54 of overtime. This overtime of $54 is added to her regular hourly pay of $480 (40 hours x $12), for a total of $534. The $534 is her gross pay for the pay period. 

Adjust Gross Pay for Social Security Wages

Now that you have gross wages, take a closer look. Before you calculate FICA withholding and income tax withholding, you must remove some types of payments to employees. 

The types of payments not included from Social Security wages may be different from the types of pay excluded from federal income tax. 

For example, if you hire your child (under 18) to work in your business, you must take out the amount of their pay when you calculate Social Security withholding but don't take it out when calculating federal income tax withholding. 

Here's another example: Your contributions to a tax-deferred retirement plan (like a 401(k) plan should not be included in calculations for both federal income tax or Social Security tax.

IRS Publication 15 (Circular E) (pages 38-42) has a complete list of payments to employees and whether they are included in Social Security wages or subject to federal income tax withholding.

Step Five: Calculate Federal Income Tax (FIT) Withholding Amount

To calculate Federal Income Tax withholding you will need: 

  • The employee's adjusted gross pay for the pay period
  • The employee's W-4 form, and 
  • A copy of the tax tables from the IRS in  Publication 15: Employer's Tax Guide). Make sure you have the table for the correct year. 

Starting January 1, 2020, use the new IRS Publication 15-T that includes the tax tables for the new W-4 form. It also includes tables for the old W-4 form for employees who haven't changed their withholding since January 1, 2020.

Step Six: Calculate Social Security and Medicare Deductions

You must withhold FICA taxes (Social Security and Medicare) from employee paychecks. 

Be sure you are using the correct amount of gross pay for this calculation. This article on Social Security wages explains what wages to take out for this calculation.

The calculation for FICA withholding is simple.

FICA Taxes - Who Pays What?
FICA Taxes (% of employee gross pay) Employee Pays Employer Pays
Social Security Tax 12.4% (up to annual maximum) 6.2%   6.2%  
Medicare Tax 2.9% up to $200,000 1.45%   1.45%  
Additional Medicare Tax   0.9% on gross pay over $200,000 0%

Withhold half of the total (7.65% = 6.2% for Social Security plus 1.45% for Medicare) from the employee's paycheck.

For the employee above, with $1,500 in weekly pay, the calculation is $1,500 x 7.65% (.0765) for a total of $114.75.

Be careful not to deduct too much Social Security tax from high-income employees, since Social Security is capped each year, with the maximum amount being set by the Social Security Administration.

You will also need to consider the additional Medicare tax deduction due by higher-income employees, which begins when the employee reaches a $200,000 in earnings for the year. The additional tax is 0.9% of the gross pay based on the employee's W-4 status. No additional tax is due from the employer. 

Step Seven: Take State Income Tax Deductions

Most states impose income taxes on employee salaries and wages.  You will have to do some research to determine the amounts of these deductions and how to send them to the appropriate state/local taxing authority. 

Your responsibilities as an employer for deducting, paying, and reporting these taxes are discussed in this article.

Step Eight (Optional): Take Other Deductions

 You're not quite done yet with deductions. Here are some other possible deductions from employee pay you might need to calculate: 

  • Deductions for employee contributions to health plan coverage
  • Deductions for 401(k) or other retirement plan contributions
  • Deductions for contributions to internal company funds or charitable donations. 

Remember, all deductions start with and are based on gross pay. 

An Example of an Employee Pay Stub

 In the case of the employee above, the weekly pay stub would look like this: 

Employee Pay Stub
Gross Pay  Federal Income Tax Withholding FICA Tax Withholding Other Deductions Net Pay
$1,500.00  $182.15 $146.25 $0.00 $1,171.60

Don't Forget Employer Payroll Taxes

 You must make deposits with the IRS of the taxes withheld from employee pay for federal income taxes and FICA taxes and the amounts you owe as an employer. Specifically, after each payroll, you must

  • Pay the federal income tax withholding from all employees 
  • Pay the FICA tax withholding from all employees, and 
  • Pay your half of the FICA tax for all employees. 

Depending on the size of your payroll, you must make deposits monthly or semi-weekly. 

You must also file a quarterly report on Form 941 showing the amounts you owe and how much you have paid. 

If you have many employees or don't have the staff to handle payroll processing, you might want to consider a payroll processing service to handle paychecks, payments to the IRS, and year-end reports on Form W-2.

Article Sources

  1. IRS. "Topic No. 401 Wages and Salaries." Accessed Aug. 3, 2020.

  2. U.S. Department of Labor. "Overtime Pay." Accessed Aug. 3, 2020.

  3. U.S. Department of Labor. "Final Rule: Overtime Pay." Accessed Aug. 3, 2020.

  4. IRS. "Topic No. 751 Social Security and Medicare Withholding Rates." Accessed Aug. 3, 2020.

  5. IRS. "Depositing and Reporting Employment Taxes." Accessed Aug. 3, 2020.