federal withholding tax

Payroll is one of the most complicated areas of accounting because of all the rules and regulations surrounding payroll. Not only do we need to calculate taxes, but we also need to subtract things like retirement benefits, health insurance contributions and other employee contributions. This post will cover the basics of payroll and payroll taxes.

What are wages and salaries?

Wages and salaries are the compensation paid to employees for the work they do for a company. Wages are calculated based on an hourly rate and the number of hours an employee works. Salaries are a fixed amount paid to employees no matter how many hours are worked. Salaries are based on an annual or monthly rate. Other items that are considered part of wages and salaries are commission paid to sales people, bonuses paid to employees, holiday pay, and vacation pay. The total compensation paid to employees based on work performed is considered to be the total wage and salary expense for the company. This is also called Gross Payroll.

What taxes are withheld from employee compensation?

Once  gross payroll has been calculated, we can start looking at deductions. Taxes generally make up the largest portion of employee deductions. These taxes include social security and medicare taxes, withholding for federal income taxes and withholding for state income taxes. We will look at each of these taxes individually to insure that you understand each of these taxes and how the tax is calculated.

Social Security and Medicare Tax

The Social Security Act was signed into law on August 14, 1935 to provide benefits to retirees, widows, and surviving children. Medicare was later added in 1965 as a health insurance program for retirees over the age of 65. Social Security and Medicare taxes are often referred to FICA tax because of Federal Insurance Contributions Act of 1935 which allowed for the collection of the taxes to pay for these programs.

Social Security and Medicare taxes are paid by employees and matched by their employers.

The current Social Security tax rate is 6.2% and is collected on all wages until an employee earns up to the Social Security wage base limit. For 2014, that amount is $117,000. For 2015, the wage base limit is $118,500. Once an employee makes more than the wage base, no additional tax is collected. The employer is also responsible for matching 6.2% of an employee’s pay up to the wage base limit. The total percentage paid by the employee and the employer is 12.4%

The current Medicare tax rate is 1.45% and is collected on all wages. There is no wage base limit for Medicare. The employer is also responsible for matching the Medicare tax at 1.45%. The total percentage paid by the employee and the employer is 2.9%.

Federal Withholding

Federal Withholding is the amount that an employer withholds from an employee’s pay that goes toward the employee’s federal income tax liability. Each year, when the employee files his or her federal tax return (typically a 1040, 1040A, or 1040EZ), the form will compare how much the employee must pay in tax with the amount that the employee had withheld from his or her paychecks. If too much tax was withheld, the employee will receive a refund. If too little tax was withheld, the employee will owe money.

When a company hires an employee, the employee is required to fill out an . On this form, the employee indicates his or her filing status and the number of allowances the employee is claiming. The employer then uses the withholding tables from  to determine how much to withhold from an employee’s paycheck. The tables are based on the frequency of pay (weekly, biweekly, monthly) and if the employee is married or single.

It is the employee’s responsibility to properly fill out the form based on the employee’s circumstances. The employer can only withhold based on the W-4 provided.

State Withholding

Currently, there are seven states that do not have an income tax. They are:

  • Alaska
  • Florida
  • Nevada
  • South Dakota
  • Texas
  • Washington
  • Wyoming

Two additional states do not have an income tax on wages and salaries:

  • New Hampshire
  • Tennessee

If you live on any of the states not listed above, your wages are subject to state withholding for income taxes. The procedure is similar to Federal Withholding. The employee fills out a state form and the employer uses that form to calculate the tax based on state withholding requirements.

Unemployment Taxes

Employers are responsible for paying state and federal unemployment taxes for their employees. This is not a tax that is withheld from an employee’s pay. It is an employer expense.

Unemployment taxes pay for benefits paid to people who have been laid off from their job.

Unemployment tax rates and wage base limitations vary state. Most states charge a higher rate to employers that lay off more workers. Typically, the wage base is very low. The majority of states have a wage base that is less than $15,000, with 19 states having a wage base below $10,000. That means unemployment taxes are no longer charged to an employer once that employer pays an employee more than the wage base. Washington had the highest wage base for 2014 at $41,300.

The federal unemployment tax rate is 6% with an $7,000 wage base. Most employers get a credit of up to 5.4% for taxes paid to their state unemployment fund. That means that most employers pay 0.6% (less than 1%) on the first $7,000 of wages paid to each employee.

Basic paycheck and expense calculations

Our ultimate goal is to calculate the employee’s gross pay and the amount of taxes that must be withheld from the employee, as well as the employer tax expense. Net pay is the amount of the check written to the employee after taxes and other deductions are subtracted from gross pay. This is also called take-home pay. Let’s see what a basic paycheck calculation would look like for a company.

Example #1

Jeff’s Geek-O-Rama has one employee. As of January 14, the first biweekly pay date of the year, the employee had worked 48 hours and is paid at a rate of $10 per hour. According to the employee’s state and federal forms, the company will withhold 10% in federal withholding taxes and 5% in state withholding taxes. The state unemployment rate is 4% on the first $10,000 of wages paid to each employee and the federal unemployment rate is 0.6% on the first $7,000 of wages paid to each employee. 

Calculate the gross pay and net pay for the January 14 paycheck. Also calculate the company’s tax expense for this paycheck. 

There is a lot of information in this short little problem and it can seem really overwhelming. Let’s start with what the question wants us to do.

  1. Calculate the gross pay
  2. Calculate the net pay
  3. Calculate the company’s tax expense

Now we can tackle each of these one at a time. It is really important to learn the terminology so you can calculate the correct figures.

Gross pay is the amount of wages the employee earned. This is based off the number of hours the employee worked and how much the employee is paid each hour. In this case, the employee worked 48 hours over a two-week period. We know this because we are told the employee is paid biweekly (every two weeks). The employee is paid $10 per hour.

48 hours worked x $10 per hour = $480.00 gross pay

Net pay is the amount the employee takes home after all the taxes are deducted. First, determine which taxes should be withheld from the employee.

  • Social Security
  • Medicare
  • Federal Withholding
  • State Withholding

We need to calculate each of these taxes.

Social Security is 6.2% of the gross pay. Multiply the gross pay by 6.2% or 0.062.

$480.00 x 0.062 = $29.76 Social Security tax

Medicare is 1.45% of the gross pay. Multiply the gross pay by 1.45% or 0.0145.

$480.00 x 0.0145 = $6.96 Medicare tax

According to the problem, federal withholding is 10% of gross pay. Multiply gross pay by 10% or 0.1.

$480.00 x 0.1 = $48.00 federal withholding tax

According to the problem, state withholding is 5% of gross pay. Multiply gross pay by 5% or 0.05.

$480.00 x 0.05 = $24.00 state withholding

All the taxes that will be withheld from the employee’s pay have been calculated. For net pay, subtract all the taxes from the gross pay.

PT1

Of the $480.00 the employee earned, the employee will take home $371.28. The rest of the money, $108.72 will be paid to the federal and state governments on the employee’s behalf.

The last portion of the problem asks us to calculate the employer taxes. First, list the taxes that the employer must pay.

  • Social Security
  • Medicare
  • Federal Unemployment
  • State Unemployment

We need to calculate each of these taxes.

Social Security is 6.2% of the gross pay. Remember that the employee pays this but the employer does as well. Multiply the gross pay by 6.2% or 0.062.

$480.00 x 0.062 = $29.76 Social Security tax

Medicare is 1.45% of the gross pay. This is another tax that is paid by both the employee and the employer. Multiply the gross pay by 1.45% or 0.0145.

$480.00 x 0.0145 = $6.96 Medicare tax

According to the problem, federal unemployment is 0.6% of the first $7,000 of wages paid to each employee. Since this is the first payroll of the year, the employee has only earned $480.00 and is well below the $10,000 threshold. Multiply the gross pay by 0.6% or 0.006. Remember, this is less than 1% so it is 0.006.

$480.00 x 0.006 = $2.88 federal unemployment tax

According to the problem, state unemployment is 4% of the first $10,000 of wages paid to the employee. Since this is the first payroll of the year, the employee has only earned $480.00 and is well below the $10,000 threshold. Multiply the gross pay by 4% or 0.04.

$480.00 x 0.04 = $19.20 state unemployment tax

Add up all the employer taxes to calculate the total employer tax.

PT2

This is an expense to the employer on top of the wages paid to the employee. Therefore, the total cost of the employee to the employer is $480.00 in wages plus $58.80 in taxes.

In the next post, we will discuss how to record the journal entries for this payroll transaction.

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