What is wage withholding?
Employers are required to subtract taxes from an employee’s pay and to remit those taxes withheld to the government as a payment of tax on behalf of the employee. Employees then claim a credit for the amount of tax withheld from the calculated tax liability when filing a return. Specifically, employers are required to withhold federal income tax, Social Security tax, Medicare tax, and state and local taxes from the earnings of their employees.
Federally required tax withholding and their implications
Federal income tax withholding on wages
The amount of money the employer withholds from your paycheck depends on the amount of gross income made in the form of wages for the year, minus any pre-tax deductions paid out of wages before taxes are calculated.
Employers use withholding allowances to calculate the amount of federal income tax to withhold from each paycheck. Withholding allowances are chosen by the employee using Form W-4 and giving the form to the employer. For more details, see How to Figure Withholding Allowances for Form W-4.
Social Security withholding on wages
Social Security tax is withheld at a flat rate of 6.2% on gross wages after subtracting any pre-tax deductions that are exempt from Social Security taxes up to the annual Social Security wage base limit of $118,500 (for 2015). Because the Social Security tax is assessed at a flat rate with a maximum, the amount of Social Security tax withheld is usually equal to the amount of Social Security tax for which a person is liable.
However, there are some exceptions.
Exception 1, Overpaid Social Security tax: Employees who work for two or more employers may find that they have overpaid their Social Security tax if their total wage income, from all sources, exceeds the annual Social Security wage base. In this situation, the overpaid Social Security tax is refunded when the taxpayer files a return and claims the excess Social Security withholding as a credit.
Exception 2, Underpaid Social Security tax: Social Security taxes can be underpaid in three ways. Some employees who receive tips that are not reported to their employer and have no taxes withheld. In this case, use Form 4137 to calculate the amount of Social Security tax and Medicare tax on the unreported tips and report this additional tax amount on the annual tax return.
A second way is that some workers may be incorrectly classified as independent contractors instead of as employees by their employer, and in this case, the earnings would not have any tax withheld. In this case, use Form 8919 to calculate the amount of Social Security tax and Medicare tax on the earnings and report this additional tax amount on the annual tax return.
A third way is that some retirees may receive coverage under a group term life insurance policy from their former employer. Group term life insurance with a policy value over $50,000 is taxable. But the retiree might not have any cash earnings relating to their retirement benefits from which the employer could withhold taxes. In this case, the retiree’s Form W-2 will indicate the uncollected Social Security tax and Medicare tax using Box 12 code M and code N.
The retiree then adds these amounts to his or her tax return for the year. See the IRS’s Instructions for Form 1040 Line 60.
Medicare withholding on wages
Medicare tax is withheld at a flat rate of 1.45% on gross wages after subtracting any pre-tax deductions that are exempt from Medicare taxes. Because Medicare tax is assessed at a flat rate, the amount of Medicare tax withheld is usually equal to the amount of Medicare tax for which a person is liable. However, since 2013, there is a new 0.9% Medicare surtax for higher-income people. It is possible for some taxpayers not to have this additional Medicare tax withheld from their pay, and any additional Medicare tax that is due will be calculated on the tax return.
State and local withholding on wages
States and local governments may impose withholding on wage income for state income tax, local income tax, and other types of state and local taxes such as disability insurance coverage.
How to calculate withholding allowances for Form W-4
Employees inform their employers of how many withholding allowances to use when calculating the amount of federal income tax to withhold. (These withholding allowances are often used to calculate state income tax withholding as well.) There are two methods for calculating the number of withholding allowances. The first method can be found on the worksheets accompanying Form W-4. On the first page is a Personal Allowances Worksheet: this is the worksheet to use if you have only one job as an employee. On the second page is a Two-Earners/Multiple Jobs Worksheet: this is the worksheet to use if you have two or more jobs as an employee and for spouses where each spouse has a job.
The end result of these worksheets is a whole number representing withholding allowances. One withholding allowance is equal to one personal exemption for the whole year. One withholding allowance functions to remove $3,950 of gross wages from taxable wages (for 2014). Thus a withholding allowance can be thought of as a ratio reflecting the amount of tax deductions and tax credits you expect to have for the year, divided by the personal exemption amount of $3,950. The worksheets help you to work through this math. Additional worksheets are found in Publication 505. Alternatively, you can use the interactive Withholding Calculatoron the IRS.gov Web site.
Resources and Reference Material
- Tax law regarding withholding on wages is found at Internal Revenue Code section 3402 and in the Treasury Regulations starting at section 31.3401 and following. To see all the relevant sections, view the table of contents for Treasury Regulations (26 CFR 31), Subpart E.
- Publication 505, Tax Withholding and Estimated Tax, discusses withholding for individuals. (Also available as a PDF document.)
- Publication 15, Employer’s Tax Guide, discusses withholding procedures for employers. (Also available as a PDF document.)
- Form W-4 is used to set or to change the level of withholding for employees. The form includes instructions and worksheets.
- Withholding is discussed in-depth in chapter 26 of J.K. Lasser’s Your Income Taxand in chapter 4 of the Ernst & Young Tax Guide.
- Paycheck and withholding calculator from PaycheckCity: this calculator can be used to double check the calculation of withholdings on a paycheck or to find out what withholding on a paycheck could be using different withholding allowances.