Every small business with employees needs to calculate withholding tax so that they can deduct the correct amount from each employee’s paycheck to cover their tax obligations as defined by the IRS.
In order to calculate withholding tax, employers will refer to the IRS’s income tax withholding table and each employee’s W-4 form to ensure that they deduct the appropriate amount of federal income tax.
The two main methods to calculate withholding tax are the “percentage method” and the “wage bracket method”. Whichever method you choose, you will need the following in order to make your calculations:
- The IRS tax withholding tables and tax calculator, located on the IRS website which can be found here
- Gross pay for each employee for the pay period
- Each employee’s W-4 forms
Learning to calculate withholding tax correctly will ensure that all your employees are taxed at the appropriate rate.
Calculating Withholding Tax – How it’s Done
Once you have the documents and information above, you are ready to begin calculating withholding tax. Follow these three simple steps to make your calculation:
STEP 1 – REVIEW W-4 FORMS
Each employee’s W-4 will show their filing status, details of their dependents, information on additional income and any extra deductions the employee has requested.
STEP 2 – REVIEW PAYROLL
In order to calculate withholding tax, you’ll need to gather the following information from your payroll records:
- Payroll period. This covers how frequently you pay your employees and the amount of time in each period.
- Gross salary of each employee for each period.
STEP 3 – CHOOSE YOUR METHOD OF CALCULATION
There are two methods by which you can calculate withholding tax. These are:
The Percentage Method
The precise method for calculating using the percentage method differs depending on whether you use a manual or automated payroll system. However, the instructions are included in IRS publication 15-T and will take you step-by-step through the process, including calculating each employee’s wage, allowing for relevant tax credits and determining the final amount you should withhold.
The Wage Bracket Method
This is a simpler method of calculating withholding tax. Each employee’s tax deduction is calculated using the IRS income tax withholding tables (which we linked above) and full instructions are also found on publication 15-T.
Withholding Allowances
Until 2020, withholding allowances were exemptions from federal income tax that employees could claim using their form W-4. However, as of the 2020 version of the W-4 form, these allowances are no longer being used.
2020 Income Tax Rate
In 2020, federal income tax is paid at seven rates:
* 10%
* 12%
* 22%
* 24%
* 32%
* 35%
* 37%
Which rate is applied to an employee will depend on a number of factors, including their marital status, number of dependents, filing status and, of course, their gross income.
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