When paying employees, employers must take into account withholding allowances to know how much to deduct for income taxes.
- A withholding allowance reduces the amount of income tax you withhold from an employee's paycheck.
- Employees file IRS Form W-4 to indicate their withholding allowances.
- Once you know your employees' withholding allowances, you can calculate their federal income taxes using the wage bracket method.
- This article is for business owners who are looking to understand withholding allowances and how they affect employee paycheck deductions.
A lot more goes into paying employees than just adding up the hours they work each week and multiplying it by their pay rate. You also have 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 to do so, first you'll have to master withholding allowances.
What is a withholding allowance?
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.
Key takeaway: A withholding allowance lowers the amount of income tax you deduct from an employee's paycheck.
How do withholding allowances work?
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 any taxpayers.
For tax year 2020 and onward, the IRS has 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, though other types of allowances remain.
Key takeaway: Your employees determine their withholding allowances using IRS Form W-4, which you should collect from them when they begin working for you.
How many allowances can an employee claim?
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:
- One deduction for each qualifying child under 17 One deduction for each other dependent
- One deduction each for qualifying home mortgage interest, charitable contributions, state and local taxes up to $10,000, medical expenses of greater than 7.5% of the employee's income, student loan interest or deductible IRA contributions
Employees may also ask you to withhold more 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:
- Works multiple jobs
- Earns nonjob dividends, interest and retirement income
- Is filing jointly with a spouse
- Requests additional withholding for any reason
Key takeaway: 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.
When and how can employees change their withholding 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:
- Family. Marriage, divorce, childbirth and adoption all affect the number of allowances that employees can claim for spouses, children and other dependents.
- Taxable finances. Employees who buy a home, retire or file for Chapter 11 bankruptcy may need to alter their withholding amounts.
- Nontaxable finances. Although interest income, dividends, capital gains, self-employment income and some IRA distributions are not subject to withholdings, changes in the amounts of each type of earning may require allowance adjustments.
- Finance adjustments. New IRA deductions, student loan interest deductions and alimony expenses may trigger withholding allowance changes.
- Jobs. An employee who begins or stops working a second job may need to update their withholding allowances. An employee who is married to a spouse who begins or stops working a second job may need to do the same.
- Itemized deduction or tax credits. Employees that have new costs – including charity contributions, interest, medical expenses, taxes, dependent care expenses, education credits, child tax credits or earned income credits – may need to adjust 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.
Key takeaway: Employees can file a new Form W-4 to change their withholding allowances whenever they experience certain changes to their families, finances or income.
How to calculate how much to withhold from employee pay
Once your employees determine their number of withholding allowances, you'll need to 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:
- Divide the amount specified in Step 4(a) of your employee's Form W-4 by your annual number of pay periods.
- To this amount, add the employee's total taxable wages for the pay period.
- Divide the amount specified in Step 4(b) of your employee's Form W-4 by your annual number of pay periods.
- Subtract this amount from the sum you calculated in step two, and record it as the adjusted wage amount. Round up all negative numbers to zero.
- Compare the adjusted wage amount to the appropriate wage bracket table in IRS Publication 15-T, and record it as the tentative withholding amount.
- Divide the amount specified in Step 3 of your employee's Form W-4 by your annual number of pay periods.
- Subtract this amount from the tentative withholding amount. Round up all negative numbers to zero.
- Add this amount to the amount specified in Step 4(c) of your employee's Form W-4. This sum is how much federal income tax you will withhold from your employee's paycheck this pay period.
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.
IRS Publication 15-T offers a step-by-step guide to the percentage method. However, with robust payroll software in place, you might not even have to think twice about properly calculating your employees' federal income tax withholding and, in doing so, keep your company out of trouble with the IRS.
Key takeaway: Use the wage bracket method for manually calculating federal income tax withholding, or if you use automated payroll software, double-check your program's math using the percentage method.