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.

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 that can be taken from an employee's paycheck, like retirement benefits, health care costs, or special funds and donations. 

Start with 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). 

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 income and withholding are correctly calculated on the employee's pay. 

The IRS has a new W-4 form that must be used beginning January 1, 2020, for all new employees and for current employees making withholding changes.

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. 

Step Two: Calculate Gross Pay

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 $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 she worked 38 hours in the pay period, her 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 $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 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 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. 

These articles on overtime might help you sort out the overtime pay issue: 

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 excluded 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 exclude the amount of their pay when you calculate Social Security withholding but don't exclude it 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.

The steps to get to the federal withholding amount are complicated. This article on How to Calculate Federal Income Tax Withholding gives you an overview of the process. 

Step Six: Calculate Social Security and Medicare Deductions

You must deduct 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 exclude for your calculation.

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. 

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 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

And Don't Forget to Pay Your 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 too many employees or don't have the staff to dedicate to 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.