More goes into paying employees than adding up the hours they work each week and multiplying it by their pay rate. You also need to account for tax withholdings. Even though you probably know that you have to withhold taxes from employees’ paychecks, you might not understand exactly how to do so. After all, taxes are notoriously complex. That said, even new business owners can easily calculate the most variable federal withholding tax category: income taxes. But first, you’ll have to master withholding allowances.
A withholding allowance is an exemption that lowers the amount of income tax you must deduct from an employee’s paycheck. A larger number of withholding allowances means smaller income tax deductions, and a smaller number of allowances means larger income tax deductions. Some employees, such as those whose tax filing status is single, may claim zero allowances.
Each employee determines their withholding allowances using IRS Form W-4. That’s why so many guides to business taxes suggest obtaining W-4 forms from new employees even though the IRS never collects this form for taxpayers.
The IRS recently introduced a new version of Form W-4 that may make determining allowances easier for certain employees. This new W-4 reduces the number of sections on the form from seven to five. That’s because the Tax Cuts and Jobs Act no longer allows for personal or dependency allowances, although other types of allowances remain.
There is theoretically no maximum number of allowances employees can claim. If you get the sense that your employee is taking an exceptionally large number of allowances, you may want to consult an accountant for tax advice and ask your employee to do the same.
Here are some examples of allowances employees can claim:
Employees may also ask you to withhold additional tax instead of taking allowances that reduce their tax liability. You may need to withhold more tax from your employees’ paychecks if the employee meets one or more of the following criteria:
Employees can claim several allowances and even ask you to withhold additional taxes from their paychecks, but you may want to speak with an accountant if an employee is requesting excessive allowances.
Employees can change their withholding allowances whenever they want by filing a new Form W-4 with you. That said, it’s not wise for an employee to update their W-4 forms or adjust their allowances on a whim; life changes should be the primary trigger for withholding-allowance changes.
Here are some examples of life changes that may prompt employees to change their withholding allowances:
You may want to remind your employees of the possible need for withholding allowance adjustments as a new year approaches or if you become aware of a tax law change.
Employees can file a new Form W-4 to change their withholding allowances whenever they experience certain alterations to their families, finances or income.
Once your employees determine the number of withholding allowances they need, you’ll calculate the total amount to withhold from their paychecks. Keep in mind that withholding allowances pertain only to federal income taxes; you must deduct flat-rate Medicare and Social Security taxes, and if applicable, wage garnishments and benefit premium payments, from all employee paychecks.
To calculate how much federal income tax to withhold from your employees’ paychecks each pay period, you can use the wage bracket method:
If you use payroll software, you likely won’t need to use the wage bracket method. In that case, you can either rely on your payroll software’s withholding calculator to accurately determine your employees’ federal income tax withholding or double-check your payroll software’s math using the percentage method.
Use the wage bracket method to manually calculate federal income tax withholding. Or, if you use automated payroll software, double-check your program’s math using the percentage method.
When you’re taking care of taxes and payroll, you’ll want to be sure you’re doing everything correctly. IRS Publication 15-T offers a step-by-step guide to the percentage method. However, with robust payroll software in place, you might not have to think twice about properly calculating your employees’ federal income tax withholding. In doing so, you’ll keep your company out of trouble with the IRS.