Secret of How Payroll Tax Withholdings Are Calculated

The Secret of How Payroll Tax Withholdings Are Calculated

All of an employee’s wages are subject to tax withholding, including federal income, Social Security, Medicare, state, and local income taxes. If an employee receives the same salary every payroll period, then he can anticipate what his net paycheck will be each time. On the other hand, if an employee’s wages vary because of changes in the number of hours worked or different rates of pay, then the employee often cannot predict what his take-home pay will be. The value of certain fringe benefits may also impact the amount of taxes withheld.

Social Security and Medicare taxes are a straight percentage of taxable wages, so these taxes are easily calculated. But Federal Income Taxes, most state taxes, and some local income taxes, are what are referred to as graduated income taxes. The tax rate increases if the individual earns more, and there are certain deductions and credits that must be considered as well. By focusing on how Federal Income Taxes are calculated, this article will explain how the process works.

How Does a Graduated Income Tax Work?

The principle behind a graduated income tax is that the more money an individual earns, the higher the tax rate. For instance, according to Internal Revenue Procedure 2014-61, in 2015 the first $9,225 of an individual’s income is taxed at 10%, the next $28,225 is taxed at 15%, the next $53,300 is taxed at 25%, and so on. On the other hand, the tax brackets for a married person or a head of household are different.

In addition, a certain portion of a person’s income can be deducted from his total income before it is subject to income tax. For instance, in 2015 a taxpayer may deduct $4,000 from his income for himself and for each dependent claimed on his income tax return. In addition, he may either claim a standard deduction of $6,300 or itemize deductions to reduce his income further.

Once the individual’s or family’s taxable income has been calculated, the taxpayer’s federal tax liability is calculated by multiplying the amount of income in each tax bracket by the percentage for that bracket.

For instance, suppose an individual earns $42,600 in one year. The standard deduction of $6,300 and $4,000 for a single exemption can be subtracted from that amount, leaving taxable income of $32,300. The federal tax liability would be calculated as follows:

Tax on income in 10% bracket=$9,225 x .10=$922.50
Tax on income in 15% bracket=$23,075 x .15=$3,461.25
Total tax liability=$922.50 + $3,461.25=$4,383.75

Why Are Income Taxes Withheld from Every Paycheck?

There are two basic reasons why income taxes are withheld from every paycheck.

Some income taxes are only collected at the source
Payment of the taxpayer’s tax liability is spread out over a period of time

What are income taxes that are collected at the source? Rather than collecting certain taxes from the taxpayer when the taxpayer files a tax return, these taxes are calculated on income when it is earned, withheld from the employee’s income, and deposited with the taxing agency within a specified period of time. These taxes are either based on a fixed percentage or are a flat amount, and employees are not required to file a tax return for these taxes.

As an example, in Philadelphia, Pennsylvania, the following taxes are based on straight percentages, and the employee does not have to file a tax return for them:

Social security tax
Medicare tax
Philadelphia City Wage Tax
Employee share of Pennsylvania Unemployment Tax

There are a number of advantages to both the taxpayer and the government if taxes are withheld over a period of time instead of being due all at one time. The taxpayer avoids the danger of using all of his income as it is earned and then not having the funds available to pay the taxes. And the government has use of the funds long before the tax return deadline.

How Are Tax Withholdings Calculated?

In Publication 15, Employer’s Tax Guide, the IRS provides calculations and tax tables to determining how much to withhold from an employee’s payroll. The tax tables are based on the length of the payroll period (weekly, biweekly, semimonthly, monthly, etc.), the employee’s marital status, and the number of withholding allowances. But what is the basis of these tax tables?

Tax withholding tables are based on projecting an employee’s annual income based on his current wages, calculating the annual tax liability, and allocating a portion of that annual liability to the current payroll period.

For instance, the calculation might be done this way. Suppose the employee is paid biweekly (26 payrolls each year), the employee is single with 1 withholding allowances, and he is paid $1,400 in wages for the payroll period.

Projected annual wages ($1,400 x 26 periods=$36,400)
Standard deduction for unmarried individual=$6,300
Personal exemptions=$4,000
Taxable federal income ($36,400 - $6,300 - $4,000=$26,100)
Federal tax liability on $26,100=$3,453.75
Tax liability allocated to pay period ($3,453.75 / 26 periods=$132.84)

That amount can be checked in the Tax Tables of Publication 15. If the employee is single and only has one job, he can claim 2 withholding allowances on his Form W-4. Based on 2 allowances, the withholding amount for wages of at least $1,400, but less than $1,420, is $134.00. That is $1.16 more than was calculated above, so an additional $30.16 would be withheld during the year, and that amount would be refunded when the Form 1040 is filed at the end of the year.

Payroll Tax Withholdings Are Not So Mysterious After All

Payroll tax withholding doesn’t have to be a mystery. Since all earned income is subject to income taxes, the above information should help clarify why and how such tax withholdings are calculated.