If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by HERE for a complete list of classes currently available and HERE for more information about the website.
Class Objectives: To understand the basics of payroll tax withholdings, including how they’re calculated and how to update federal tax withholding.
Prerequisites: TX301: Income Tax Basics
Handout: Payroll Withholding Tax Summary
Assignment: Download the income tax spreadsheet for Excel | Google Docs (previews in lecture material below)
Do you remember your first job when you were so excited that you were making (fill-in-the-blank) minimum wage dollars an hour and were finally going to have some money of your own? How about your disappointment when you saw how little was left after all the payroll withholding taxes? Well, I would bet that after the initial disappointment you probably just got used to seeing those extra taxes come out and began to only rely on that net pay.
Perhaps, though, you’ve gotten too used to all those taxes coming out and you’ve started to ignore your withholding taxes altogether. If you’re getting serious about creating a detailed financial plan, it’s important for you to know exactly how they are calculated and how to change your federal and state tax withholding when needed.
To name a specific example: if you aren’t aware, not only are HSA contributions taken out on a pre-tax basis for federal (and most state) purposes, but they are also deducted from your wages when calculating Social Security and Medicare FICA taxes. That can save you an additional 7.65%! How’s that for a little additional encouragement to save money in your HSA account?
TYPES OF WITHHOLDING TAXES
Employers are required to withhold taxes and pay them directly to government organizations on behalf of their employees. Otherwise, they would have to count on employees saving that money themselves each month until they had to pay the IRS (and state governments) themselves. Since we know how good Americans are at saving (hint: not good), it’s understandable why this method is used.
Payroll withholding taxes include:
- FICA taxes for Social Security
- FICA taxes for Medicare
- Federal income tax withholding
- State income tax withholding
- Local income tax withholding
For those that are self-employed, this concept is the same in that a self-employed person is required to make quarterly payments on their own to the federal and state governments or pay significant penalties. However, we will solely focus on payroll withholding in the case of an employer/employee in this class to simplify the concepts.
Once you’ve got payroll withholding taxes figured out, you will know how to properly adjust your federal and state withholding taxes and have a good understanding of exactly what is and isn’t included in calculating wages for tax withholding purposes.
SOCIAL SECURITY TAX WITHHOLDING
When you pay the social security portion of FICA taxes, you are essentially paying for a type of insurance. You might see the abbreviation “OASDI” on your paycheck. This stands for “Old Age, Survivor and Disability Insurance.” The social security system in the U.S. not only benefits those at full retirement age (currently age 67 for anyone born after
The social security system in the U.S. not only benefits those at full retirement age (currently age 67 for anyone born after 1960), but also provides benefits in the case of a long-term disability or death (to the surviving family members).
Because the benefits you’ll receive are based on your personal income history, the withholding rate is a percentage of your income, currently at 6.2% of wages.
Social Security taxes currently are paid for 2016 on a maximum cap of $118,500 in wages. This maximum is increased nearly every year. So, for 2016, the maximum annual Social Security FICA taxes you would be responsible for is $7,347. If only there was such a cap on federal income tax (of course the opposite is true)! The maximum Social Security wages go up to $127,200 for 2017.
If you look at your own personal 2015 W-2 form, you’ll see that there is a difference in the wages for federal income tax (line 1) and the wages for social security (line 3).
To arrive at the social security wages on line 3 of the W-2, you make the following calculation:
To see how much you’ve paid into the Social Security system to date, you can go to the Social Security Online Services website and click on “Get Your Social Security Statement’. This statement will also show you your current expected retirement, disability, and survivor benefits. We’ll talk more in depth about Social Security in a future class.
MEDICARE TAX WITHHOLDING
Medicare is the hospital insurance for people 65 and over. There are several different parts that make up the Medicare system, with varying premiums. However, many of the benefits are covered by younger people paying the Medicare tax for the elderly people that currently use the benefits. Just to clarify, Medicaid is a different program that covers low-income families and people. Some elderly people qualify for Medicaid, but it is completely separate from the Medicare system.
Medicare tax is based on the same wage base as social security tax at a 1.45% tax rate. To reiterate the formula is:
A significant difference between Social Security and Medicare withholding is that there is no wage limit on which Medicare withholding is applicable.
In addition to the 1.45% Medicare tax, individuals that make over $200,000 also are required to pay an additional 0.9% in Medicare tax on the excess over $200,000. There are some adjustments on the federal income tax return depending on your filing status and total income from both spouses, etc. so if you make over $200,000 you may want to do more research about the additional tax. Just know that your employer will be required to withhold the additional 0.9% once you reach the $200,000 threshold on your Medicare wages.
FEDERAL TAX WITHHOLDING
Federal withholding is based on a slightly different calculation of wages that accounts for additional items that are specifically excluded from federal income tax. The main change to the formula is the subtraction for retirement contributions. The formula now shows:
Federal tax withholding gets significantly more complicated than Social Security & Medicare tax withholding. Since federal income tax is a lot more involved than just a flat percentage of your income, there are deductions and exemptions to be accounted for in determining how much tax to withhold. Your paystub should actually list this amount separately as “federal taxable wages”.
As you see in the chart above, you first calculate the wages before allowances. Remember the W-4 form you (arbitrarily) filled out when you started at your employer? I would be willing to be that you probably didn’t feel terribly confident about trying to come up your number of allowances. However, we are going to change that.
The best way to come up with the number of allowances to claim on your W-4 is to project your income and deductions for the year and calculate your expected federal income tax liability. The IRS has a withholding tax calculator that you can use, but I prefer to use my own spreadsheet and/or tax software (I personally use Turbo Tax).
If you’re doing this for the next year (for example, right now for 2017), you would need to project the entire year. If you’re doing this mid-year (for example, I did a mid-year calculation in June 2016), you would use the actual income and deductions up to the current date and projected income and deductions for the remainder of the year.
After projecting your total income tax liability, you will then back into the number of allowances you should claim on your W-4 to pay that amount of tax to the IRS during the year.
Going through the process step-by-step is the best way to demonstrate this method. Note that if your income is significantly variable from paycheck-to-paycheck, you may want to use an average and would definitely need to check several times during the year to make sure that enough taxes are being withheld.
STEPS TO ADJUST YOUR FEDERAL WITHHOLDING
1. Estimate your income, deductions and credits for the year
Start with your most recent paystub and then project out your gross income for the remainder of the year. This will be fairly easy if you are on a fixed salary, but obviously more difficult if you have variable income. Just give it your best estimate. Also, project your other payroll items that will impact your federal withholding such as before-tax deductions (listed in the charted above) so that you have a total taxable income number to start with.
Also determine an amount for the total of other income items, such as interest, dividends, capital gains, rental properties, etc.
Using your previous year tax return as a guide, now move on to estimating your tax deductions and credits. If you itemize, this will be things such as property and state income taxes, mortgage interest and charitable deductions. If you don’t have enough deductions to itemize, you will use the standard deduction.
Your number of personal exemptions should be fairly straightforward, but if you have any changes (such as having a baby or taking on the care of an elderly parent), be sure to include them.
2. Calculate your expected total tax for the year
There are several simple, tax calculators out there that you can use to estimate your taxes for the year. The best one out there (in my humble opinion), is Turbo Tax’s W-4 Withholding Calculator. This is a great tool if your return is fairly simple, as it doesn’t include more advanced tax items. It also allows you to adjust the withholding allowances at the end of the calculator to see the impact of adjusting the number of allowances (basically skipping my other steps!).
I will also be sharing my tax projection spreadsheet in the next class (TX303: Intermediate Income Tax). I prefer to use a spreadsheet so that I can easily go back at a later date and update and adjust amounts without having to enter all my information again.
Sometimes when I have more advanced tax issues involving rental properties or credit adjustments, I will create a new version of my return in the prior year tax software and get an estimate that way (knowing that personal exemption amounts and tax tables will be slightly different from that past year, but this is generally close enough for my purposes).
3. Calculate how much tax you should pay in for the remainder of the year
If you are doing this calculation mid-year, subtract the amount of federal tax you’ve already paid through withholding from the amount of tax you are estimated to owe in step 2. Then, take this remaining tax amount and divide it by the remaining number of paychecks through the end of the year. This is your desired minimum desired withholding amount. I recommend adding about 5-10% as a buffer to make sure that you are for sure covered and not going to owe taxes when you file your return.
If you are doing an estimate for the next tax year (right now for 2017), divide your expected total tax by the number of pay periods in the year.
- Weekly = 52 pay periods
- Biweekly = 26 pay periods
- Semimonthly = 24 pay periods
- Monthly = 12 pay periods
4. Match the desired withholding amount to the number of allowances
Once you know how much you want your employer to withhold from each paycheck, it’s now a matter of converting this dollar amount to the number of allowances you should claim on your W-4 to make this happen.
Yes, I do have a spreadsheet for this (of course)! The calculation starts by determining federal taxable wages for each pay period (again, much more simple if you don’t have variable income!). In the next section, input your current number of withholding allowances (which can be found listed on your pay stub) and verify that your current federal income tax withholding amount matches that shown in the spreadsheet. Note that there are two separate calculations for married and single filers. It is possible that you are listed as a single filer, even if you’re married (for example, if you didn’t report this on your W-4 correctly or if you elected to be treated as a single filer for withholding purposes).
Note that there are two separate calculations for married and single filers. It is possible that you are listed as a single filer, even if you’re married (for example, if you didn’t report this on your W-4 correctly or if you elected to be treated as a single filer for withholding purposes).
Note that there are 2 separate calculations for married and single filers. It is possible that you are listed as a single filer, even if you’re married (for example, if you didn’t report this on your W-4 correctly or if you elected to be treated as a single filer for withholding purposes).
Once you’ve determined that your current taxable wages and withholding allowances match your pay stubs, you can use the allowance analysis at the bottom of the spreadsheet to match up your desired withholding amount with the number of allowances you need to claim to arrive at that amount.
For example, if you (a married person) determine that you want $250 withheld from each paycheck, you would want to claim only 4 allowances (as compared to the 6 allowances currently claimed) in the simple example above. Be sure to round up and withhold a little extra to ensure that you don’t end up owing!
5. Fill out Form W-4 and provide to your provider.
After you’ve done all this work to determine how much you want to be withheld from your pay, the last step is to update Form W-4 (previewed above) and turn it into your employer. Note that there may be a delay in the withholding changes. Many large employers offer the ability to change your W-4 allowances online, so check for that to expedite the process!
STATE & LOCAL TAX WITHHOLDING
State and local municipalities generally use adjusted gross income from the federal income tax return as their taxable base, so the formula to determine the wages for withholding is generally the same as for federal withholding. There are some differences to state taxable wages, so you may need to research your specific state’s guidelines. For example, a few states exempt military pay from state taxes and a few others don’t allow HSA contributions as a state tax deduction.
There are some differences to state taxable wages, so you may need to research your specific state’s guidelines. For example, a few states exempt military pay from state taxes and a few others don’t allow HSA contributions as a state tax deduction.
To find the formula for state withholding tax in your state, research on your state website or through Google. Once you know how federal withholding works, it should be easy for you to research your state withholding and follow their formula.
EXAMPLE: THE SMITH FAMILY
Jim Smith is paid on a monthly basis and currently claims 4 federal withholding allowances. A sample paycheck from Jim Smith is shown below:
Based on this paystub, his calculations of Social Security and Medicare withholding taxes would be as follows:
And the calculation of his Federal withholding tax based on claiming 4 allowances would be:
Your homework assignment is to analyze your current tax withholding on your pay (if you are an employee and not self-employed). The spreadsheet includes a tab to input your wage and deduction items to understand how FICA withholding is calculated for the homework assignment. the sheet to calculate federal wages is previewed earlier in the class.
- IMPROVING – Go through your most recent paystub and examine how each withholding tax has been calculated using the spreadsheet.
- INVESTED – Go through your most recent paystub and examine your withholding as listed above. Also, determine your ideal number of allowances for the remainder of the year to minimize your refund and consider changing your W-4 for the updated amount.
- UNSTOPPABLE – Go through your most recent paystub and ideal number of allowances as explained above. In addition, calculate your next year (2017) ideal number of allowances.
HANDOUT: Payroll Withholding Tax Summary
I’ve summarized the basics of payroll withholding taxes in the handout previewed below. Click on the image below to download the PDF version.