Overview: In this article, we'll explain how federal employment taxes are withheld and the employer’s liability for withholding and depositing employment taxes.
What Is Defined As A Taxable Wage?
One of the very first things most people notice when they look at their paycheck is that the gross pay is always much higher than the net pay. The main reason - every governmental agency wants a piece of the pie, if you will, from your gross pay.
One of the first facts to discuss is taxable wages. The IRS defines taxable wages as “all remuneration for services (including noncash benefits).” Publication 15, (Circular E), Employer’s Tax Guide, states “Wages subject to federal employment taxes generally include all pay you give to an employee for services performed.
The pay may be in cash or in other forms. It includes salaries, vacation allowances, bonuses, commissions, and taxable fringe benefits. It doesn’t matter how you measure or make the payments. Amounts an employer pays as a bonus for signing or ratifying a contract in connection with the establishment of an employer-employee relationship and amount paid to an employee for cancellation of an employment contract and relinquishment of contract rights are wages subject to social security, Medicare, and FUTA taxes and income tax withholding. Also, compensation paid to a former employee for services performed while still employed is subject to employment taxes.”
You can also find information about supplemental wages in Publication 15-A and taxable and nontaxable benefits in Publication 15-B. It is important to understand these concepts but we will not discuss them in detail here.
An initial concept which is important to taxability is the idea of constructive receipt. Wages are considered to be paid when the employee actually or constructively receives their paycheck - free of restrictions. Even if the employee does not have the check in hand, if it has been set aside for an employee, it is considered constructively received.
Taxing tips can be somewhat confusing as some tips are left in cash and others are left on a credit card or debit card. The constructive receipt and thus the taxability is when they are reported and then recorded with the payroll. If the reported tips are at least $20 in a calendar month, they are taxable for all federal employment taxes (and most state taxes). If the wages paid to the employee is not enough to collect all of the taxes, the taxes are collected in the following order:
Social security and Medicare on regular wages
Federal income tax on regular wages
Social security and Medicare on tips
Federal income tax on tips
In the case there is not enough money to deduct the social security and Medicare taxes, the shortage or uncollected amounts get reported on the employee’s Form W-2 in box 12 with codes A and B. The employee will pay these taxes (and any uncollected federal income tax) when they file their Form 1040. The employer is still responsible for their portion of the social security and Medicare.
Factors That Affect Federal Income Tax Withholding (FITW)
It is vital to withhold the correct amount of federal income tax from each employee's check. If we do not, we could be held liable for the amount that should be withheld. There are a number of factors that go into the calculation including (no particular order):
The pay frequency (weekly, biweekly, semi-monthly, etc)
The employee’s elections on Form W-4 (filing status, deductions, credits, etc)
Whether the wages are considered supplemental or regular
Any benefit deductions which are pretax (§125) or deferred (§401(k))
Regardless of which method is used to calculate the taxes, the basis for the calculation is the pay frequency or pay period. And as mentioned in an earlier training, it is not unusual for larger companies to have more than one pay frequency (e.g., biweekly for hourly employees and semi-monthly for salaried employees). Publication 15-T, Federal Income Tax Withholding Methods, is based on the number of pay periods in the year.
There are four basic methods for calculating FITW:
Wage Bracket Method
Flat Rate - Optional and Mandatory (supplemental wages)
Starting in 2020, with the introduction of the new Form W-4, the IRS published Publication 15-T with the various methods of calculating FITW. Because there was not a requirement for all employees to complete the new Form W-4 (like in 1986 during the last major tax reform legislation), IRS had to develop methods of calculating FITW utilizing the old (legacy) and new Forms W-4. The worksheets were designed to calculate the FITW either manually or electronically using these worksheets and corresponding tables.
For the percentage method, there are 3 worksheets (tables) that can be used.
Worksheet 1, Percentage Method Tables for Automated Payroll Systems and Withholding on Periodic Payments of Pensions and Annuities, is used by nearly all computerized payroll systems and can be used regardless of the year the employee’s Form W-4 is for. (An employee can never use a prior year’s form when updating or providing a new form).
Worksheet 4, Percentage Method Tables for Manual Payroll Systems With Forms W-4 From 2020 or Later, is used (generally) when calculating a manual check.
Worksheet 5, Percentage Method Tables for Manual Payroll Systems With Forms W-4 From 2019 or Earlier, is also generally used for calculating a manual check.
The only difference between the two worksheets (4 & 5) is the year of the most recent, valid Form W-4.
For the wage bracket method, there are 2 worksheets (tables) that can be used. These are generally only going to be used to calculate a manual check. The only difference between these two worksheets is the year of the most recent, valid Form W-4.
Worksheet 2, Wage Bracket Method Tables for Manual Payroll Systems With Form W-4 From 2020 or Later
Worksheet 3, Wage Bracket Method Tables for Manual Payroll Systems With Form W-4 From 2019 or Earlier
The flat rate method is used for supplemental wages. The definition of supplemental wages can be found in Publication 15, (Circular E) Employer’s Tax Guide. In it, the IRS defines supplemental wages as “wage payments to an employee that aren’t regular wages. They include, but are not limited to, bonuses, commissions, overtime pay, payments for accumulated sick leave, severance pay, awards, prizes, back pay, reported tips, retroactive pay increases, and payments of nondeductible moving expenses. However, employers have the option to treat overtime pay and tips as regular wages instead of supplemental wages.”
If the year-to-date (YTD) supplemental wages is equal to or less than $1M, the optional flat rate can be utilized. The current optional flat rate is 22% (2022). If the YTD supplemental wages exceed $1M, the mandatory flat rate MUST be used. The current mandatory flat rate is 37% (2022). If an employee claims exempt on Form W-4, the optional flat rate will not result in a FITW deduction. However, if the mandatory rate must be used and the employee is claiming exempt, the mandatory rate must be used.
These rates come from the Publication 15-T percentage tables.
The last method is the aggregate method and is actually a combination of taxing regular and supplemental wages together. This calculation utilizes either the percentage method or the wage bracket method (any appropriate worksheet). This calculation is a 3-step process.
Calculate the FITW on the regular wages
Calculate the FITW on the combined regular and supplemental wages
Subtract step 1 from step 2 and withhold that amount on the supplemental wages
Example: Theodore is paid biweekly and has regular wages of $1,500. He also earned a bonus of $500 this pay period. Theodore claims Single with no other entries on a 2022 Form W-4. Using the wage bracket method the taxes would be calculated as follows:
FITW on regular wages ($1,500) = $ 112.00
FITW on combined wages ($2,000) = $ 173.00
Difference = $173 - 112 = $ 61.00
FITW on Bonus using optional flat rate = $ 110.00