The Basics of Withholding Taxes for Employees

Getting tax withholdings right can be extremely daunting. Failure to pay the IRS or state taxing authority the correct amount could end up costing you thousands of dollars in penalties and interest. For many employers, an outright failure to pay could result in personal liability for employment taxes.

Payroll tax withholding covers more than just federal taxes. It also addresses any state tax obligations, local tax requirements, and Federal Insurance Contributions Act (FICA) Taxes. If you, as an employer, do not pay these correctly, you could have both the federal and state taxing authorities upset with you, and your employee may have to pay into the government at the end of the year. You can avoid all of these potential problems by simply ensuring that you are withholding for everything you are supposed to—in the right amount.

The Payroll Tax Process

As an employer, your first step is figuring the gross amount of pay for the employee for that pay period. You then use information obtained by the employee regarding their exemptions to determine how much should be withheld to pay taxes. You must also deduct a specific amount for FICA taxes as well. The remaining amount should be given to your employee as his or her net income or used to fund other benefits, such as the employee’s portion of health insurance or a retirement plan.

Employee Exemptions

Employees can claim exemptions to decrease the amount of taxes that are withheld from their paycheck. These exemptions will depend on who the employee can claim as a dependent on his or her tax return.

The employee will indicate on Form W-4 how many exemptions he or she would like to take. Some employees choose to take fewer exemptions to avoid having to pay in for their tax obligations at the end of the year. Ideally, however, most employees will try to “break even” in claiming their exemptions.

FICA Obligations

Unlike federal and state taxes, FICA obligations are based on a specific percentage of an employee’s income. As an employee, you can expect to pay 6.2% on your first $128,000 of earnings for Social Security. You will also have an additional 1.45% taken out to pay for Medicare. There is no limitation on income for Medicare withholding—you will pay 1.45% on all of your income.

As an employer, you have to match these payments. That means that the actual fee is doubled per employee. As a self-employed individual, you must pay the full amount on your own, which is 12.4% for Social Security and 2.9% for Medicare.

Federal Unemployment Taxes

The Federal Unemployment Tax Act, in association with state unemployment systems, will provide unemployment compensation payments to workers who have lost their jobs. While the employee does not pay this tax, it is based on how much the employee earns, and employers may be able to claim a credit for having to pay this tax.

Contractors and Freelancers

Workers who work on contract or do freelance work for your company generally do not have any taxes withheld from their income. Instead, they pay their taxes at the end of the year or on a quarterly basis. Instead of giving these individuals a W-2 at the end of the year, they will receive a 1099-MISC from your company.