How to Calculate Withholding and Deductions from Employee Paychecks
Calculating Federal Income Tax Withholding, FICA Tax, and More
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.
UPDATE: The New Tax Law Affects Withholding Calculations
The Tax Cuts and Jobs Act, signed by President Trump on December 22, 2017, has changed the tax rates for many Americans. These rate changes mean changes to withholding tables and may require new W-4 forms for many employees. The IRS has released updated tax tables and employers were required to implement the necessary changes by February 15, 2018.
The details of how these changes affect your payroll processes are spelled out in this article.
What's the Difference Between Deductions and Withholding?
Withholding is a term used for federal or state taxes, like income tax and FICA taxes, that are taken from employee pay. Deductions are for other amounts which can be taken from an employee's paycheck, like retirement benefits, health care costs, or special funds and donations.
Use Gross Pay for All Calculations
Gross pay is the amount of employee pay for the payroll period. When you calculate the amounts of withholding and deductions, you must use the employee's gross pay amount for each calculation. The calculations are not progressive, with lesser and lesser amounts being used for the calculations. See the detailed calculation example below for more information on how this works.
The only exception to this rule is when you calculate federal income tax withholding using the percentage method (explained below).
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 income and withholding are correctly calculated on the employee's pay.
In addition to the employee's name and address, the most important information is:
- The employee's social security number
- The employee's marital status,
- The number of allowances the employee is claiming and
- Any additional amount the employee wants to have taken from each pay.
The marital status, allowances, and additional amounts will be needed in calculating withholding in Step Four.
Employee paychecks start out as gross pay. Gross pay is the total amount of pay. For salaried employees, it's an 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 what kind of employees you have, read this article on the difference between salaried and hourly employees.
Here are examples of how gross pay 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 $1250 ($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 she worked 38 hours in the pay period, her gross pay for that paycheck is $456.00 ($12 x 38).
But you are not done with gross pay yet if overtime is paid. 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 $455 a week ($23,660 annually), even if they are classified as exempt.
The federal labor law requires a minimum required overtime of one and one-half times the hourly rate for all hours over 40 in a week. You can pay more than this required overtime, but for our purposes 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 a 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, totally $54 of overtime. This overtime is added to her regular hourly pay of $480 (40 hours x $12), for a total of $534. This is her gross pay for the pay period.
These articles on overtime might help you sort out the overtime pay issue:
To calculate Federal Income Tax withholding you will need:
- The employee's 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. The table changed effective January 1, 2018, so you'll need the 2018 table.
Go to the page on Publication 15 that says: "Percentage Method Tables for Income Tax Withholding"
Look for the table that matches:
- Marital status. Single (including the head-of-household status) is on the left and married is on the right.
- Pay period type. This ranges from weekly to annual (meaning the person gets paid once a year). Bi-weekly is every other week (every other Friday, for example), and semi-monthly would be twice a month (the 1st and 15th, for example).
- Then find the person's gross pay on that table.
Let's say you are looking at the Weekly payroll period for a Married person.
Look down the left side to find the amount of weekly gross pay for that person. Let's say it's $1500. Find $1500 in the "Over ... But not over" list. $1500 is over $525 but not over $1626.
You'll see this line:
Amount of income tax to withhold is:
Over- But not over- of excess over-
$525 $1626 $35.90 plus 15% --$525
There are several steps to this next part.
1. Put down $35.90 from the "Amount of Tax to Withhold" column.
2. Then, you need to find the excess of your employee's pay from the number in the "of excess over" column. Subtract $525 from $1500; that gives you $475.
3. Multiple $475 by the 15% in the third column. That gives you $146.25.
4. Add the $146.25 to the $35.90 to equal $182.15. That's the amount you withhold from the person's pay for federal income tax.
The IRS has a withholding calculator to make this process easier if you have many employees.
Next, you'll need to calculate FICA taxes.
You must deduct FICA taxes (Social Security and Medicare) from employee paychecks. The calculation for these deductions is pretty straightforward. The amount of FICA tax is 15.3% of the employee's gross pay.
Half of the total (7.65%) is withheld from the employee's paycheck, and half is paid by the employer.
For the employee above, with $1500 in weekly pay, the calculation is $1500 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 specific payment amount for the year. The additional tax is 0.9% of the gross pay, and it starts at $200,000, based on the employee's W-4 status. No additional tax is due from the employer.
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.
Remember to use gross pay again for the state income tax deduction.
Back to All About Payroll Taxes
Step Seven: 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 are based on gross pay.
Finally, an Example of How The Employee's Pay Stub Will Look
In the case of the employee above, the weekly pay stub would look like this:
Gross Pay FIT Withholding FICA Withholding Other Deducts Net Pay
$1500.00 $182.15 $146.25 $0 $1171.60
Using the Percentage Method Tables to Calculate Federal Income Tax Withholding
The percentage method for calculating withholding is an alternate calculation method. This calculation is based not on gross pay but on net wages after the deduction for total withholding allowances. For 2018, the IRS has published details on Notice 1036 explaining how the percentage method works.
First, you deduct the total number of allowances (on Line 5 of the form) from the gross pay for the correct payroll period. If an employee has two allowances and is paid weekly, the total to deduct would be $159.60. If the employee's weekly pay is $650.00, the amount used in the calculation would be $650 minus $159.60, or $490.40. Then use the table on Notice 1036 to calculate the withholding in the same way as in Step Four.
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.