When you get your paycheck, it will inevitably have less on the line reading “total net pay.” You may have agreed to a salary of $50,000 a year, for instance, but you also have to pay taxes on that amount. While you do your taxes in April each year, your employer is taking money out of each check and submitting it to the IRS. This ensures that when April 15 rolls around, you won’t owe penalties for underpaying taxes throughout the year, but with so many line items on your paycheck, it can help to know what they mean.
How much you pay in federal income taxes over the course of the year depends on how much you make.
How Paycheck Taxes Work
When the income tax system first started, taxpayers were handed a bill for the previous year each spring. They could also pay in quarterly installments. However, over time, the system was modified so that employers are the ones responsible for taking taxes out and submitting them throughout the year.
Once the tax season is over, each employee gets a form detailing the total income and tax withholdings for the year, at which point they file to make sure enough was withheld. If the employer didn’t hold out enough, the taxpayer may owe money. If too much was withheld, the taxpayer will likely see a refund.
Tax withholdings actually start with the Form W-4 you complete when you start a new job. The employer uses the information to determine how much to take out of each check. The goal is to get within 90 percent of the taxes due. If your employer takes out less than 90 percent during the tax year, you may owe penalties on the amount you underpaid. If you live in one of 41 states with state income tax, you’ll also have taxes withheld and submitted to state authorities.
Read More: W-2 Forms: What It Is, Who Gets One & How It Works
Understanding Your Paycheck
On your paycheck, you’ll see your taxes itemized, usually after your gross earnings are displayed. “Gross” refers to the money you’re owed before taxes are taken out. Your gross earnings may be divided out by regular wages, tips, bonuses, holiday pay, overtime pay, sick pay, bereavement pay or any other combination of money you earned. This will be totaled, with the sum listed as your gross pay.
From your gross pay, amounts are eliminated to satisfy your tax debt. Those include federal income tax, FICA and state income tax. If you have any deductions taken from your paycheck, those will be listed, as well. You may have an amount sent to a vacation savings plan, for instance, or you may agree to have pretax funds put into a health savings account or a flexible spending account. All of that will be deducted from your gross pay to arrive at the final total, which is your net pay.
Read more: How to Read a Paycheck Stub
Federal Income Taxes
On a federal level, there are two major tax withholdings you’ll see for each paycheck. The first is the federal income tax, which is based on the information you input on your W-4 and the tax tables provided in Publication 15. These tables direct employers to the amount of tax to withhold based on the employee’s marital status and income. The tables make it easy for employers, allowing them to determine how much to take out whether you’re paid weekly, biweekly, semimonthly, monthly, quarterly, semiannually or annually.
How much you pay in federal income taxes over the course of the year depends on how much you make. The Tax Cuts and Jobs Act changed the tax brackets, so if you had it down before, chances are you may find your annual tax bill isn’t the same as it was a few years ago.
If your salary is $50,000 in 2019 and 2020, then your tax bracket is 22 percent. That meant you’ll pay $4,453.50 plus 22 percent of the amount over $40,126. For the same salary, the 2017 rate was 25 percent. That meant you paid $5,226.25 plus 25 percent of the amount you earned over $37,950. Overall, that means your tax bill has been reduced, so you may have a pleasant surprise in the form of a refund, especially if you didn’t adjust your withholdings.
What Is FICA?
The Federal Insurance Contributions Act mandates that employers withhold taxes from employee paychecks to pay for an employee’s Social Security and Medicare once they’re retired. This ensures that when it is time for retirement, you have at least some way to pay for living expenses and medical care. You’ll see this on your paycheck as FICA and, in total, each employee has 15.3 percent of his income submitted to the IRS each year – 12.4 percent goes to Social Security tax and 2.9 percent goes to Medicare tax. However, the employee doesn’t pay the full 15.3 percent.
Read more: Does Everyone with Income Pay FICA?
For taxpayers on an employer’s payroll, the 15.3 percent FICA tax is split in half, with the employer paying 7.65 percent and the employee paying the other 7.65 percent. So compared to the income tax, FICA is much less noticeable than the income tax taken out of each check. However, it’s important to note that only the first $137,700 of your income is subject to Social Security taxes in 2020. For amounts above that, you and your employer will only pay 2.9 percent for Medicare.
State Income Taxes
In most states, you’ll also see a deduction on your paycheck for state income tax. This will usually be displayed as your state's name abbreviated and the words “state income tax.” Employers work with the state to get a tax permit so that they can pay taxes. They also check with the state department of revenue to find out how to submit the taxes they withhold from each paycheck.
Just as employees complete a W-4 form for federal taxes, there is also one for state income taxes. In California, for instance, it’s called Form DE 4 and it simply asks the employee to calculate withholdings based on calculations done on a work sheet.
Crossing State Lines
Where things get complicated is when an employee crosses state lines. It may be that she lives in one state and works in another or vice versa. It could also be that she performs work in more than one state for the company during the tax year. The default is to withhold taxes based on the state where the employee’s work is performed, which answers the question about working in one state and living in another.
However, in some states, there are rules of reciprocity, which means that there may be something in place that requires you to withhold income taxes for the state of residence, rather than where the work is performed.
If the employee works in more than one state, though, the general rule is that you’re supposed to tax wages and other compensation to the state where the work was performed. This requires ongoing tracking and calculation, though. Software can make this part of things easier, but it’s important to set something up. States are increasingly performing audits on companies that perform work in their area to ensure taxes are being remitted accurately.
Taxes for the Self-Employed
You learn quickly the answer to, “What taxes does an employer have to match?” when you’re self-employed because you’re responsible for paying your own taxes. Nobody withholds money from each paycheck and remits it to federal and state authorities on your behalf. You have to track how much you’re earning and submit quarterly payments, provided you expect you’ll owe more than $1,000 in taxes in the tax year. The IRS has a worksheet to help self-employed taxpayers determine whether they should pay quarterly and, if so, how much to pay.
Although self-employed professionals will pay both state and federal income taxes the same as everyone else, they’ll also pay a self-employment tax. This replaces the FICA notation seen on payrolled employees' paychecks. Unlike those on a payroll, self-employed taxpayers don’t enjoy a match on their FICA taxes, so they’re responsible for the full 15.3 percent. However, those who are self-employed can deduct the employer contribution of FICA when they’re figuring their adjusted gross income.
Legality of Cash Employees
Can employees be paid in cash? You might be surprised to know the answer to that is “yes.” It is not illegal to pay employees in cash as long as you withhold and submit taxes on every dollar you pay. At the end of the tax year, you’ll be responsible for providing a Form W-2 detailing how much the employee earned in wages, taxes, bonuses and other compensation.
Keeping track off all of this can be tricky, though, which is why tax experts caution against it. One example of employees receiving cash, though, is those who receive tips. Workers earning $20 or more per month in tips must report their total tip income and pay taxes on it.
The big problem comes in when employers try to pay cash “under the table,” which means they aren’t reporting it to the IRS. According to the IRS, this type of payment is one of the top types of employment tax noncompliance. If you’re caught failing to report the income you’re paying your workers, you could face severe monetary penalties and possible jail time. In addition to being above board in your tax payments, you should also keep meticulous records so that you can prove it if you’re ever audited.
Employers and Federal Taxes
Do employers have to pay federal income tax? Yes. Small-business owners and partners will report the income they brought in on their personal income tax, even if they had a team of employees. Partners split that income and report it separately on their tax returns and they pay self-employment tax, as well as income tax, on their earnings.
However, if a business registers as a corporation, the business files a tax return and its owners are paid in the form of a salary each year. Owners and shareholders are taxed on the salaries and distributions they receive, not the income from the business itself. But the business is taxed on those profits and if those profits are distributed to shareholders, the shareholders are taxed on the amount they receive.
How to Reduce Taxability
If you’re uncomfortable with the amount coming out of each paycheck, there are things you can do to keep more of that money. The first is to look into every tax-deferred savings option available to you, including health savings accounts and flexible spending plans through your employer. With these, you can put pretax dollars into an account, where you can use them to pay your medical expenses. You can also redirect some of your funds pretax into a retirement savings account such as a 401(k) or traditional IRA.
Another way to reduce your taxable income is to take as many deductions as you can. However, there are fewer options to payrolled employees under the new tax laws and, at the same time, an increase in the standard deduction makes it likely you’ll be better off not itemizing. For the 2020 tax year, taxpayers get a $12,400 standard deduction or $24,800 if you’re married filing jointly.
- Investopedia: Understanding The U.S. Tax Withholding
- IRS: Publication 15
- Nerdwallet: Standard Tax Deduction: How Much It Is in 2020-2021 and When to Take It
- Tax Foundation: 2020 Tax Brackets
- IRS: Topic Number: 751 - Social Security and Medicare Withholding Rates
- State of California: EMPLOYEE’S WITHHOLDING ALLOWANCE CERTIFICATE
- NJBIA: Multi-state Tax Withholding Considerations
- Patriot Software: Is Paying Employees Cash Under the Table Legal?
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.