How to Figure Tax Withholdings
All businesses other than sole proprietorships with no employees other than the owner are normally required to figure withholding taxes and deduct them from employees' paychecks. As a businessperson, you will probably find it much easier to do this with a computer and payroll software, but it's important to know the process. An understanding of how to figure tax withholdings can help you identify and prevent costly errors. It takes only a couple of missed keystrokes to convert a paycheck for a few hundred dollars into a mistake that can cost you thousands.
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Things You'll Need
- IRS Form W-4
- IRS Publication 15, Circular E
- State/local withholding instructions
- Calculator
Instructions
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1
Find the employee's gross earnings. Gross earnings include wages or salary, commissions, tips, and other compensation. In some cases employers include reimbursements for business expenses in paychecks, but these are normally not taxable income and should be added in after withholdings are calculated.
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2
Find the taxable income portion of gross earnings for federal income tax. Take the number of withholding allowances from the employee's W-4 form and multiply it by the amount for one withholding allowance (from IRS Publication 15, Circular E Withholding Tables -- find a link in the References section) for the pay period. Subtract this amount from gross earnings. If the employee has requested on the W-4 that additional tax be withheld, subtract this amount as well. Finally, subtract the amount of any tax-exempt items such as contributions to a 401(k) plan. As an example, a single employee paid biweekly with gross earnings of $1,000 and two withholding allowances at $140.38 (2009 amount) and no other deductions would have taxable income of $1,000 minus $280.76, or $719.24.
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3
Calculate federal income tax to be withheld. Federal income tax is levied on a sliding scale. To figure income tax, refer again to the Withholding Tables. No tax is assessed on the first portion of taxable income, and then progressively higher percentages are withheld from each successive tax bracket. For a single employee with biweekly taxable income of $719.24 (the example from Step 2), there is no tax on the first $102. Again using 2009 rates, 10 percent of the amount from $102 to $400 is withheld ($29.80) plus 15 percent of $319.24 (the amount over $400), which is $47.89, for a total federal income tax withheld of $77.69.
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4
Figure tax withholding for Social Security and Medicare. For Social Security tax, the rate is 6.20 percent of gross earnings up to a yearly limit (as of 2010 this limit was $106,800 -- find the updated limit find a link in References. There is never an income limit on Medicare taxes). If an employee's year-to-date earnings exceeds the limit, do not withhold any further Social Security tax. There is no limit on Medicare tax. For Medicare, withhold 1.45 percent of all gross earnings. Employers must contribute an equal amount of both taxes as well that is not deducted from employee earnings.
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5
Calculate state and local income taxes, if any. Most states levy an income tax but each state establishes its own formula for figuring tax withholdings. This is also the case for some municipal governments. You will need to obtain the instructions for calculating these taxes from your state or local Department of Revenue or Taxation.
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6
Subtract the amount for each tax from the employee's gross earnings. In addition you need to subtract any other items such as health insurance premiums and contributions to retirement plans and add any nontaxable items such as reimbursements for expenses. Follow the instructions in Publication 15, circular E (find a link in References) to determine the required schedule for remitting the taxes to the IRS.
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Tips & Warnings
The IRS requires that taxes withheld be remitted according to a set schedule which may be found in Publication 15, Circular E.
In addition to taxes withheld from the employee's paycheck, a business is responsible for paying their contribution to Social Security/Medicare and for federal (FUTA) and state (SUTA) unemployment taxes.
