Federal Income Taxes

Federal Income Taxes

An employer is required by law to deduct income taxes from employee pay. If it uses a payroll supplier, then the calculation of the appropriate income tax amounts is completely invisible to it, since the supplier handles this task. If the employer calculates income taxes using a software package, then the software supplier will issue new tax tables each year to accompany the software. In this case, too, there is little need for an employer to know how the tax tables function. However, if a business calculates its payroll internally and manually, then it needs the wage bracket tax tables published by the IRS. They are contained within Publications 15 and 15–A, which can be downloaded from the IRS web site at www.irs.gov. These tables are published for a variety of scenarios, such as for single or married employees; a variety of payroll periods; and for withholding allowances numbering from 0 to 10. An example is shown in Exhibit 7.2, which is taken from page 35 of the 2002 Publication 15–A. It lists the amount of income, Social Security, and Medicare taxes to be withheld for a single person. Note, however, the exhibit is incomplete; it shows only taxes due for wages in a small range, and for 0 through 5 withholding allowances.

Example. Ms. Storm Dunaway works in the Humble Pie Company's baking division, which pays its employees once a week. She earned $462 in the past week and has claimed three withholding allowances. Using the wage bracket table in Exhibit 7.2, it's easy to find the correct wage bracket that contains her pay range (of at least $460 but less than $470), and then shift horizontally across the table from that wage bracket to the column for three withholding allowances, which shows that her total taxes should be $65.57.

Two alternative calculations are shown in Exhibit 7.3, which show the underlying formulas that were used to derive the wage bracket tax table in Exhibit 7.2. Using Alternative 1 in Exhibit 7.3, subtract a dollar amount from an employee's base wage that corresponds to the number of withholding allowances taken, multiply by a base tax rate, and then reduce the tax rate by a fixed amount to arrive at the income tax. (Note that these tables do not include the Social Security or Medicare taxes, as was the case in Exhibit 7.2.) Using Alternative 2 in Exhibit 7.3, subtract a dollar amount from an employee's base wage that corresponds to the number of withholding allowances taken, reduce the taxable wage by a fixed amount, and then multiply by a base tax rate to arrive at the income tax. Either method results in an identical income tax.

Exhibit 7.3: Alternative Formulas for Calculating Income Taxes

Example. The Humble Pie Company's baking division is switching to an in-house computer-based payroll processing system and wants to ensure that both IRS formula tables contained within it are correctly calculating income tax withholdings. As a baseline, they use the $65.57 withholding that was calculated for Storm Dunaway in the previous example. By netting out the 6.2 percent Social Security and 1.45 percent Medicare taxes that were included in that figure, they arrive at a baseline income tax of $30.23.

Using the formulas listed under Alternative 1 for a weekly pay period for a single person in Exhibit 7.3, they first subtract $57.69 from Ms. Dunaway's gross pay for each withholding allowance claimed, which reduces her gross income for calculation purposes to $288.93. They next multiply this amount by 15 percent and then subtract $13.30 from it, as specified in the table. This results in a calculated income tax of $30.04, which is substantially the same figure found under the wage bracket method.

They then switch to the formulas listed under Alternative 2 for a weekly pay period for a single person in Exhibit 7.3, which requires the same deduction of $57.69 from Ms. Dunaway's gross pay for each withholding allowance claimed, once again resulting in gross pay of $288.93. Under this approach, they subtract $88.67 from the gross pay to arrive at $200.26, and then multiply by 15 percent to arrive at the same income tax of $30.04.

• Basis is annualized wages. Under this approach, calculate an employee's annual pay rate and then determine the annual withholding amount in the IRS Annual Payroll Period tax table. Divide this amount by the number of pay periods in the year to determine the deduction for an individual pay-check.

• Basis is partial-year employment. This method can be used only at an employee's written request, which must state the last day of work with any prior employer, that the employee uses the calendar year accounting method, and that the employee does not expect to work during the year for more than 245 days. The company then compiles all wages paid to the employee during his or her current term of employment, including the current pay period. The next step is to determine the number of pay periods from the date of the employee's last employment, through and including the current pay period, and divide this amount into the total wages figure, resulting in an average wage per pay period. Use the correct tax table to arrive at a withholding amount for the average wage, then multiply this amount by the total number of pay periods, as already calculated. Finally, subtract the total amount of withholdings already made, resulting in the withholding to be made in the current pay period.

  This approach is requested by employees such as part-time students or seasonal workers who expect to be out of work so much during the calendar year that their full-year pay will drop them into a lower tax bracket, resulting in smaller income tax withholdings.

• Basis is year-to-date cumulative wages. This method can only be used at an employee's written request. To calculate it, compile all wages paid to the employee for the year-to-date through and including the current pay period, and divide the sum by the total number of year-to-date pay periods, including the current period. Then use the percentage method to calculate the withholding on this average wage. Multiply the withholding amount by the total number of year-to-date payroll periods, and subtract the actual amount of withholdings made year-to-date. The remainder is the amount to withhold from the employee's wages during the current pay period.

  This complicated approach is requested by employees who may have had an excessive amount of taxes withheld from their pay earlier in the year, perhaps due to a large commission or bonus payment that bumped them into a higher income tax bracket. By using the cumulative wages calculation, these excessive withholdings may sometimes result in a one-time withholding on the payroll in which this calculation is requested that is much smaller than usual.