Every first-time jobholder is probably a bit surprised to find the amount on their first paycheck is less than their total earnings. The difference between the amount of money earned, or gross pay, and the amount a worker takes home is due to taxes. All wage earners are required to pay certain federal taxes that are automatically withheld from their wages. Some states also withhold for state income tax. Understanding exactly how much in taxes is taken out of your paycheck can help lessen the shock.
Determining Federal Income Tax Withholding
The Internal Revenue Service expects taxpayers to pay taxes on wages at the time they’re earned. This is done through federal income tax withholding. The amount of federal income tax withheld varies by individual, based on the data in Form W-4, which all employees are required to submit to their employer.
The form includes information about whether a worker will file a tax return as married or single, the number of withholding allowances claimed by the worker and whether an additional amount should be withheld from each paycheck. Form W-4 includes a worksheet to help employees determine the correct amount of allowances for their financial situation. The IRS also provides a free online paycheck calculator to help determine the correct number of withholding allowances.
Social Security and Medicare Tax Withholding
Besides income tax withholding, there are additional paycheck deductions for Social Security and Medicare taxes. These two deductions are sometimes referred to as payroll taxes or FICA (for Federal Insurance Contributions Act). They are used to support retired workers and pay for their medical benefits, as well as for supporting disabled workers and their dependents. Both FICA taxes are assessed at a flat rate for all workers. For the 2017 and 2018 tax years, the tax rate for Social Security is 6.2 percent. For 2018, the maximum amount of gross income subject to this tax is $128,400. The Medicare tax rate is 1.45 percent, with no maximum income limit.
Paycheck Deductions for $1,000 Paycheck
Looking at a simple example can help clarify exactly how federal tax withholding works. For a single taxpayer, a $1,000 biweekly check means an annual gross income of $26,000. If a taxpayer claims one withholding allowance, $4,150 will be withheld per year for federal income taxes. The amount withheld per paycheck is $4,150 divided by 26 paychecks, or $159.62. In each paycheck, $62 will be withheld for Social Security taxes (6.2 percent of $1,000) and $14.50 for Medicare (1.45 percent of $1,000). Depending on the state where the employee resides, an additional amount may be withheld for state income tax.
Penalties for Not Withholding Enough
The IRS expects to be paid taxes as soon as wages are earned. If the information in an employee’s W-4 results in too little being withheld for taxes, the employee could be subject to a penalty for underpayment of taxes, even if the taxes are subsequently paid when the employee files a tax return.
The only employees who are exempt from withholding taxes are those who had no tax liability in the previous year and expect to owe no taxes in the current tax year. All other employees need to be sure to have enough withheld to cover their tax liability. Those who have significant additional income from investments or interest are encouraged by the IRS to make additional estimated tax payments to cover nonwage income.
2018 Tax Law
In 2018, the flat tax rate for FICA remains unchanged from 2017. However, the Tax Cuts and Jobs Act of 2018 included several changes that potentially affect the amount an individual should have withheld, including an increased standard deduction and removal of personal exemptions. To make sure the correct amount is withheld for 2018 and future tax years, the IRS encourages employees to recalculate their withholding allowances and file a new Form W-4 with their employer if their allowances have changed.
- U.S. Tax Center: Withholding Tax: The Basics
- IRS: Tax Withholding for Individuals
- Taxpayer Advocate Service, "Vol. 2, TAS Research and Related Studies: A Conceptual Analysis of Pay-As-You-Earn (PAYE) Withholding Systems as a Mechanism for Simplifying and Improving U.S. Tax Administration," Page 11. Accessed April 1, 2020.
- Internal Revenue Service. "Understanding Taxes -- Theme 2: Taxes in U.S. History." Accessed April 1, 2020.
- Internal Revenue Service. "Form W-4," Accessed April 1, 2020.
- Tax Foundation. "State Individual Income Tax Rates and Brackets," Pages 1–10. Accessed April 1, 2020.
- Social Security Administration. "Contribution And Benefit Base," Accessed April 1, 2020.
- U.S. Congress. "H.R. 748 - CARES Act." Accessed April 1, 2020.
Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.