Employers are required by law to withhold money from employee paychecks for income taxes. These are generally called withholding taxes and do not include the Social Security and Medicare (FICA) taxes employers are also responsible for withholding. This applies to salary and hourly employees, full- and part-time employees, but not contractors.
To handle income tax withholding without errors, you’ll need a solid process to calculate, withhold, and pay the correct amounts.
How Withholding Tax Works
As an employer, you are responsible for withholding taxes from your employees’ paychecks and paying them quarterly. If you have a payroll provider that offers full-service payroll, like Gusto, it will handle this for you. Otherwise, you will need to ensure you know how to do payroll and implement this as part of your payroll process. Want to learn how to do payroll on your own the right way? Check our new How to Do Payroll e-book.
You’ll need to use the IRS withholding tables and the employee’s W-4 form to determine how much you should withhold. And once you determine the correct amount, deduct this from the employees’ take-home pay and set it aside for paying taxes. You must deposit the withholding tax with the IRS on a monthly or semiweekly basis. Check IRS Publication 15 to determine which schedule fits your business.
To report the amount of withholding taxes you paid in for each employee, submit Form 941 quarterly. Alternatively, submit Form 944 once a year if your business is very small and owes less than $1,000 in withholding and FICA taxes for the year.
Taxes Included in Income Tax Withholding
How much you withhold depends not just on federal taxes, but also your state and local laws. Not all states have income tax withholding. On that same note, some local areas have special income tax withholding requirements. Below are some of the most common. The percentages may differ from year to year. Check the annual tax tables if you don’t have a payroll software or service that updates these for you.
- Federal income taxes (as outlined in the IRS Code Publication 15)
- State income tax
- Any local taxes, such as school district, city local income tax, or county taxes
To learn about more employer taxes that businesses are required to pay and/or withhold and pay, check out our article on employer payroll taxes.
Determining Withholding Tax Amounts
As an employer, you’re responsible for ensuring your wage-earning employees fill out a W-4 form so the government (and you) can determine their withholdings.
To meet withholding tax requirements, you must determine the income taxes that need to be withheld according to each employee’s W-4 form. If an employee has not provided a W-4, you should calculate the taxes based on a single person with no adjustments. This will result in the highest amount of taxes being withheld and should prevent the employee from owing additional funds at tax time; if anything, they’ll be entitled to a refund.
The IRS Circular E provides the current payroll tables to determine current withholding amounts. Many payroll software companies also provide these and even integrate them into their software each year, so the tax rates update automatically.
Did you know? In 2020, the IRS created a simplified W-4 form for employees. New employees need to use it, but employees who have already filled out a W-4 are not required to submit a new one unless they want to make updates.
There are two primary differences in the new W-4. First, it’s simpler. Employees only need to fill out the first section (contact information and filing status) and the fifth section (signature). The other sections are optional. Second, employees can no longer request adjustments using withholding allowances. According to the IRS, the form is now more transparent, simple, and accurate. Employees can no longer claim personal or dependent exemptions to change their withholding amount.
If employees only fill out steps one and five, their withholdings are calculated based on standard deductions and tax rates, with no adjustments. Employees should strive to have 90% or more of their total income taxed if they want to avoid an unpleasant surprise around tax time. Thus, they should fill out the other areas if they:
- Work multiple jobs
- Have passive income (royalties, pensions)
- Are married filing jointly
- Have dependents
- Want an extra withholding for other reasons, such as to ensure a refund
Income Tax Withholding Exemptions
While most, if not all, of your employees will be subject to withholding taxes, there may be times you have an employee who is exempt. In this scenario, you would not withhold income taxes from the employee’s paychecks and would, instead, input $0 for income taxes withheld on their year-end W-2 forms. To be exempt, an employee must meet the following criteria:
- Have owed $0 in income tax for the prior tax year
- Expect to owe $0 in income tax for the current tax year
Usually, this pertains to low-income employees, especially those with a large number of dependents and many personal deductions. If an employee wrongfully claims to be exempt when they aren’t eligible, you (the employer) will not be penalized. As long as you have a current W-4 form on file showing they claimed to be exempt, you will be protected. However, they will end up with a large tax bill plus penalties at tax time.
Pay That Is Subject to Withholding Tax
The IRS can tax just about any income your employees earn—even gambling winnings. Employee earnings you’re most likely concerned about are:
- Salary and hourly pay
- Reimbursements and other expense allowances under a non-accountable plan
- Bonuses, commissions, and tips
Withholding Tax vs Estimated Tax
Employers deduct withholding taxes from their wage-earning employees’ paychecks. Any self-employed workers, contractors, partners, and S corporation shareholders who anticipate paying more than $1,000 in taxes when they file should pay estimated taxes on income to avoid a large bill and tax penalties when they file their return.
The IRS offers a tax estimator for determining how much employees will need to pay. Encourage your employees to highlight any huge discrepancies by comparing what is currently being withheld to what the tax estimator shows. For a more accurate assessment, employees should gather information from their most recent pay statements for all sources of income, plus their spouse’s (if applicable), as well as their last tax form. If any adjustments need to be made, they should submit a revised W-4 Form.
How and When to Update Withholding Tax Details
Employees should be encouraged to change their withholdings when something alters their income status and, therefore, the amount of income tax that you, the employer, withhold. At that time, the employee should fill out a new W-4 form. Here are the most common instances in which employees should update their W-4 forms:
- Lifestyle changes like marriage, divorce, a new child, or a home purchase
- Job changes like getting a second job or retiring
- Filing for Chapter 11 bankruptcy
- A large change in itemized deductions like medical expenses, interest expenses, charitable contributions, or education
Withholding employee taxes keeps your business on the right side of the law, ensures you can pay your employer taxes, and keeps employees from having to pay a large lump sum come April 15th. You need to pay withholdings for federal income taxes and state or local taxes, depending on where your business and employees are located. Payroll services usually determine the correct withholding amounts for you, but if not, the guidelines above will get you started.