Federal Withholding on Wages for Income Tax, Medicare, and Social Security
Employers are required to subtract taxes from an employee's pay and remit them to the U.S. government in a process referred to as "federal withholding." Employees can then claim credit for the amount withheld when they file their tax returns. Employers are required to withhold federal income tax, Social Security tax, and Medicare tax from employees' earnings.
Federal Income Tax Withholding
The amount of money an employer must withhold and remit to the IRS depends on how much in the way of gross income you've earned in the form of wages for the year. Pre-tax deductions, such as retirement plan contributions, are subtracted first before withholding is calculated on the remaining balance.
Employers use Form W-4, completed by their employees, to calculate the amount of federal income tax to withhold from each paycheck.
How to Calculate Withholding on Form W-4
Withholding allowances corresponded with the number of personal exemptions that taxpayers were entitled to claim on their returns for themselves, their spouses, and their dependents prior to tax year 2018. Then the Tax Cuts and Jobs Act (TCJA) eliminated personal exemptions.
The IRS has rolled out a brand new Form W-4 for the 2020 tax year to accommodate this tax code change. The new form is reported to be much easier to use than the old one. It does much of the work for you. It's largely a matter of answering some questions, and the form will provide you—or, more accurately, your employer—with the correct amount to be withheld from your pay.
You can use the Tax Withholding Estimator available on the IRS website if you're still feeling a bit confused when tackling the new Form W-4.
Changing Your Withholding
You're not stuck forever with the withholding calculation you arrived at by completing Form W-4. Errors can be fixed by submitting a new, revised form to your employer. You can change your W-4 at any time during the tax year, adjusting for more withholding or less depending on your circumstances.
In fact, the IRS advises that you do so when:
- You (or your spouse) pick up a second job or lose secondary sources of income.
- You experience major changes in your life, such as marriage, divorce, death of a spouse, or the birth or adoption of a child.
- You qualify for fewer—or more—tax deductions, credits, or adjustments to income.
It's also a good idea to review your withholding whenever there have been changes in tax law, which has occurred numerous times since late 2017.
You May Be Exempt From Withholding
A few individuals might be exempt from withholding, so no federal income tax must be withheld from their pay. This can happen because they owed no income tax in the last tax year and they don't expect to owe income tax in the current year
You can indicate that you're exempt on Form W-4 if you qualify and, in fact, you must, or your employer is still obligated to withhold income tax from your pay. And bear in mind that you could owe a substantial lump-sum tax debt at the end of the year if your calculations are wrong.
This rule applies only to income tax, not to FICA taxes—the Social Security and Medicare withholdings.
Social Security Withholding on Wages
Wages are subject to withholding in addition to the federal income tax. Social Security tax is withheld at a flat rate of 6.2% on gross wages after subtracting any pre-tax deductions that are exempt from Social Security taxation.
Not all gross wages are subject to this tax. An annual wage base limit caps earnings that are subject to withholding for Social Security. That base is $142,800 in 2021, up from $137,700 in 2020. Income over this amount isn't subject to Social Security withholding.
Because the Social Security tax is assessed at a flat rate with a maximum cap on earnings, the amount withheld is usually equal to the amount of Social Security tax for which an employee is liable. There are some exceptions, however, and taxpayers can end up overpaying or underpaying through withholding.
Overpaid Social Security Tax
Employees who work for two or more employers might find that they've overpaid their Social Security if their total wage income from all sources exceeds the annual Social Security wage base. One employer might not know about earnings from another that can push your overall wages over the wage base limit.
Any overpaid Social Security can be refunded if you claim the excess withholding as a tax credit when you file your return.
Underpaid Social Security Tax on Tip Income
Social Security taxes can be underpaid in three ways.
Some employees receive tips but don't report them to their employers, so no tax is withheld from this money. You should use Form 4137 to calculate the amount of Social Security and Medicare tax due on the unreported tips and report this additional amount on your tax return.
Misclassification as an Independent Contractor
Some workers are incorrectly classified by their employers as independent contractors rather than employees. Their earnings would not have any tax withheld in this case because independent contractors are responsible for remitting their own estimated taxes to the IRS as the year goes on.
Use Form 8919 to calculate the amount of Social Security and Medicare tax on your earnings in this case and report this additional amount on your annual tax return.
Group Term Life Insurance
Some retirees might receive coverage under a group term life insurance policy from their former employer. This insurance is taxable if the policy value is over $50,000.
But a retiree might not have any cash earnings relating to their retirement benefits from which the employer can withhold taxes for this purpose. In this case, your Form W-2 will indicate the uncollected Social Security and Medicare tax using the codes M and N in Box 12. You can then add these amounts to your return for the year.
Underpaid Medicare Tax
Medicare tax is withheld at 1.45% of gross wages after subtracting from what remains any pre-tax deductions that are exempt, just as with Social Security. Because Medicare is assessed at a flat rate and there's no wage base, the amount withheld is usually equal to the amount for which an employee is liable.
But a 0.9% Medicare surtax has been in place for higher-income earners since 2013, and this can cause under-withholding. It's possible that some taxpayers might not have this additional amount withheld from their pay, so any additional Medicare tax that's due will be calculated on the return and would become due at that time.
IRS. "FAQs on the 2020 Form W-4." Accessed Oct. 16, 2020.
IRS. "Tax Withholding for Individuals." Accessed Oct. 16, 2020.
IRS. "Topic No. 753 Form W-4—Employee's Withholding Allowance Certificate." Accessed Oct. 16, 2020.
Social Security Administration. "Fact Sheet Social Security." Accessed Oct. 16, 2020.
Social Security Administration. "Contribution And Benefit Base." Accessed Oct. 16, 2020.
IRS. "Topic No. 608 Excess Social Security and RRTA Tax Withheld." Accessed Oct. 16, 2020.
IRS. "Publication 531 (2019), Reporting Tip Income." Accessed Oct. 16, 2020.
IRS. "Group-Term Life Insurance." Accessed Oct. 16, 2020.
IRS. "Questions and Answers for the Additional Medicare Tax." Accessed Oct. 16, 2020.