What Wages Are Used to Calculate Withholding?

Wages Used to Calculate Withholding

How Withholding is Calculated
Rob Friedman/Getty Images. Rob Friedman/Getty Images

Important note: The deadline for filing W-2 forms and 1099-MISC forms for 2016 has been moved up to January 31, 2017. W-2 forms must be filed with the Social Security Administration, and 1099 forms must be filed with the IRS. Read more about the New W-2 and 1099 Tax Report Deadlines. 

 How is employee pay determined for withholding and employment tax purposes?

Employers must withhold certain amounts from employees and pay certain employment taxes to the IRS based on employee wages.

But gross pay may be reduced by specific amounts allowed by the IRS. This article explains the types of withholding deducted from employee pay and payable by employers and the types of pay which can be excluded for these purposes.

  • Federal income taxes (FIT), withheld based on the information from the employee's W-4 form and the employee's gross pay for a pay period.
  • FICA taxes (FICA) (Social Security and Medicare taxes). Social Security taxes for 2012 are withheld at the rate of 4.2% of employee wages, up to the Social Security maximum; Medicare taxes are withheld from employee wages with no maximum. FICA taxes are also paid by employers
  • Federal unemployment taxes (FUTA), which are not withheld from employee wages but are paid by the employer based on the employee's gross pay.

How is the gross pay for withholding and employment taxes determined?

Withholding for federal income tax is based on wages paid by an employer.

For the most part, all calculations for wages subject to withholding (FIT, FICA) are based on gross pay (total W-2 income before any deductions or exclusions) from that employer. The IRS says, "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 fringe benefits."

Payment not included in wages for withholding. 

There are, however, some types of payments by an employer that are not included in wages for the purpose of calculating withholding. Contributions by an employer to a qualified retirement plan are one common example of "wages" not subject to withholding. IRS Publication 15 lists specific types of payments and whether they can be excluded from calculations for federal income tax, FICA tax, and federal unemployment tax.

Some of the most common categories of wages which may (under specific circumstances) be excluded from employee wages for federal income tax, FICA tax, and federal unemployment tax purposes:

  • resident aliens
  • disabled workers wages
  • employee business expense reimbursements, if part of an accountable plan that meets IRS requirements
  • family employees, including children employed by parents, and spouses employed by spouses
  • insurance for employees (accident, health, group term life insurance)
  • interest on loans
  • tips (depending on the monthly amount

How is withholding calculated?

For the purpose of calculating FIT and FICA, an employer must start with total W-2 wages, then deduct amounts that can be excluded, in order to get a total amount to be used for calculating federal income taxes and FICA taxes.

An example of how federal income tax and FICA taxes might be calculated:

  • First, the employee's gross pay is calculated,
  • Next, any excludable items are deducted from gross pay for federal income tax withholding purposes, and federal income taxes are calculated
  • Any excludable items are deducted from gross pay for FICA withholding purposes and FICA tax withholding is calculated. Some types of payments may be excludable for FIT purposes but not for FICA purposes
  • Excludable pay for individual employees is used to reduce that employee's pay for federal unemployment tax purposes. Pay for all employees that is subject to federal unemployment tax is added up and the federal unemployment tax rate is applied to the total payroll

States usually follow federal rules for withholding, but each state is different.

Check with your state's department of revenue on state rules for calculating withholding.