If you’ve ever looked at your W2, you’ve probably noticed the boxes on the right that record the taxes withheld from your wages. After you spend a few moments daydreaming about what you could have done with that extra cash, you may wonder how those amounts are calculated. Is there even a calculation? Or are those amounts just arbitrary numbers the IRS generates to further baffle taxpayers?
Of course, for as much as we’d like to take a cynical view of the IRS, there is in fact a science behind the numbers. By better understanding payroll taxes, you'll be able to better understand your obligations as a business owner or employee. We will start with the 3 main withholding taxes. (A withholding tax is what you as a business owner is obliged to withhold from employees and pay to the IRS.)
The 3 Main Withholding taxes
- Federal Income Tax withheld
- Social Security Tax withheld
- Medicare Tax withheld
(The last two of these make up what’s known as the FICA withholding amounts.)
Federal Income Tax
When an employee is first hired, many companies require them to fill out a W4. The W4 asks for things like filing status, dependents, child care expenses, additional taxes. The information taken from the W4 is what impacts your W2 federal income tax calculation; which is more like an estimation. Just like businesses are supposed to make estimated tax payments throughout the year, employees pay their estimated income taxes through their W2 income tax withholdings. It’s not exact because the true income tax withholding amount is only set in stone when the tax return is finished and submitted. It’s possible your W2 income tax withholding was too low throughout the year, meaning you’d owe taxes. Or maybe it was too high, meaning you’d get a refund. You can always adjust this amount by contacting your payroll specialist.
FICA stands for Federal Insurance contributions Act. It includes the taxes paid by both employees and employers toward Social Security and Medicare which provide benefits to the disabled, retirees, old-age, disability insurance among other groups and health programs. 15.3% is the number to remember regarding FICA tax. Below you’ll see how that percentage is broken down.
Social Security Tax Withheld
6.2% of an employee's gross wages is paid to social security by the employee. Another 6.2% is paid to social security by the employer. Together, they make up a 12.4% contribution to social security. The employers obligation to pay this portion of the tax ends when the employee earns total wages of more than $118,500 annually.
Medicare Tax Withheld
Similar to social security, payments to Medicare are split up between the employee and the employer. 1.45% is paid by the employee and 1.45% is paid by the employer. Together this makes up 2.9%. There is no ceiling on this tax. Regardless how much an employee earns, Medicare will always be separated.
Adding the 12.4% so social security and the 2.9% to medicare equals the magic number 15.3% FICA tax mentioned earlier.
Next time you look at your W2, you’ll be able to use these percentages to see just how the amounts were calculated.
Payroll Taxes relating to Contractors and Employees
Knowing the payroll calculations can help you understand other important issues relating to 1099 contractors or W2 employees. If you have paid a non-employee more than $600 to perform work for you, then you must send him/her a 1099 that will be used as documentation for the contractor’s tax return. You get to deduct this entire payment on your taxes and you don’t need to share the FICA obligation. The contractor is fully responsible to pay the 12.4% Social security and the 2.9% Medicare. From a tax perspective, it is more beneficial for the employer to hire contracted work to avoid extra FICA taxes. However, there are strict guidelines that enforce the designation of employee or subcontractor which you can view here.