Understanding Federal Income Tax Withholding Methods

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Federal income tax withholding is a pay-as-you-go system that prevents employees from receiving large, unaffordable tax bills at the end of the year. It also fights tax evasion and encourages full participation in the economy. Like Social Security and Medicare taxes, which go toward specific programs, federal income tax withholding (FITW) funds many different government services. To calculate FITW, employers use standard tables available in IRS Publication 15-T.

Wage Bracket Method

Employers must comply with federal income tax withholding methods, ensuring accurate deductions from employees’ paychecks per the Internal Revenue Service (IRS) regulations. The amount of money an employer withholds from an employee’s paycheck is based on information they provide on tax forms. Employees can adjust the amount withheld by making changes to their Form W-4. This allows them to manage their income taxes throughout the year and avoid a large bill during tax season. Employers use the wage bracket method to refer to the federal income tax withholding tables in IRS Publication 15-T. These are based on pay frequency, filing status, and how the employee fills out Form W-4. The employer uses the appropriate table for each payroll period to find the amount of withholding to be deducted. If the employee’s taxable wages exceed the last bracket of the tables or they claim more than ten withholding allowances, you must switch to the percentage method. The percentage method is similar to the wage bracket method, except there are no limits on taxable wages or withholding allowances. You begin by finding the employee’s payroll period’s tax rate using a table in IRS Publication 15. Then, you calculate withholding by multiplying the employee’s total number of withholding allowances by the tax rate and subtracting it from the employee’s taxable wages. This method works for weekly, bi-weekly, semi-monthly, monthly, daily or miscellaneous payroll periods.

Percentage Method

Using the percentage method, employers add up an employee’s regular earnings and bonus payment for each payroll period and calculate income tax withholding concerning IRS withholding tables. Employers can use this method to calculate taxes manually or employ software programs that do the calculations automatically. With this method, an employer adds the employee’s total earnings for a pay period, including regular wages and tips, and calculates withholding concerning the withholding tables provided in Circular E or Publication 15. For example, if an employee earns $2,500 in regular wages and a $1,000 bonus in the same paycheck, federal taxes are withheld for $3,500. Because the IRS considers bonuses and other types of supplemental income as “nonstandard” wages, they get taxed at a higher rate than standard wages. Depending on your effective marginal tax rate, the percentage method can result in too much or too little federal withholding when you file your return. Whether your employer chooses the percentage or wage bracket method, they must also withhold Social Security and Medicare taxes on supplemental income. These taxes are reported annually on Form 941(opens in new window), Employer’s Quarterly Federal Tax Return, and remitted to the IRS. The employee pays 6.2% for Social Security and 1.45% for Medicare; the employer matches this amount from their revenue.

Cumulative Wages Method

The cumulative method calculates income tax withholding on supplemental wage payments such as bonuses, commissions, awards, prizes, overtime pay and expenses for accumulated sick leave. The process adds the amount of each such payment to the average wage for a period (determined using either the percentage or wage bracket methods) and then computes withholding based on that calculation. This method also applies to lump sum payments, such as payouts of unused accumulated leave, and fees for other special circumstances, including reimbursing certain expenses, such as relocation costs. Supplemental wages are not considered regular salary but may still be subject to social security, Medicare and FUTA taxes. You figure withholding on such amounts in the same way that you determine it on a regular salary, using the income tax withholding tables in Publication 15, the employee’s withholding allowances claimed on Form W-4 and the pay frequency of the employer. For example, if you award an employee a bonus of $5,000 in the current payroll period, combine it with the base salary paid to her during the same pay period and figure withholding using the biweekly payroll tables and married with three allowances. If the employer pays her a lump sum of back pay, you should combine it with the previous biweekly base salary and calculate withholding based on married with three allowances.

Other Methods

The amounts of tax withheld from paychecks depend on the information employees share with employers using Form W-4. Ideally, the amount withheld is as close as possible to an employee’s total income tax bill. This keeps taxpayers from receiving large, unaffordable tax refunds or facing huge tax bills when they file taxes. However, the IRS cannot know exactly each individual’s tax situation. Instead, the agency devises methods to help figure out how much should be withheld from each pay period. The plans are designed to be simple and accurate for payroll processors and minimize the burden on employees to submit new forms. Withholding tax is the amount of money an employer deducts from an employee’s paycheck to pay federal income taxes on their behalf. The tax withheld is a credit against an employee’s annual income tax bill and helps the U.S. maintain its “pay-as-you-go” system of collecting taxes rather than imposing a large tax bill on taxpayers at the end of each year. Employees should review and submit a new Form W-4 when they experience life changes that affect their tax situation, such as changing filing status, getting married or divorced, having children, or buying a home. They should also update the W-4 if they want to change their withholding allowances or expect to owe more or less in income tax this year.

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