Employers are required to withhold federal income tax from all employees’ wages unless the employee is exempt from the tax. The withholding amount is based on the employee’s taxable wages, marital status and number of allowances stated on his or her W-4 form, plus the withholding tax tables in IRS Circular E (or Publication 15).
Employers can calculate federal income tax withholding using either Circular E’s wage bracket method or its percentage method.
The wage bracket method is the most straightforward approach, as it tells you the exact amount to withhold based on the employee’s taxable wages, marital status, number of allowances and payroll period. No calculations are needed.
However, this method stops at 10 allowances and limits the amount of wages that can be used to calculate withholding — which brings us to the percentage method.
How the Percentage-Withholding Method Works
The percentage method has no wage or allowance limits. Therefore, you can use it if the employee’s wages exceed the wage bracket’s limit or if he or she has more than 10 allowances. This approach is more complex than the wage bracket method because it involves more calculations.
First, you will need to determine the value of the employee’s W-4 allowances. According to 2018 Circular E, one allowance for a weekly pay period is worth $79.80. For a biweekly pay period, the amount doubles to $159.60. For a semimonthly pay period, one allowance comes to $172.90, and for a monthly pay period, one allowance comes to $345.80.
So if an unmarried employee earns taxable wages of $1,700 biweekly and has two allowances, the total allowance amount would be $319.20. To arrive at the amount subject to withholding, subtract $319.20 from $1,700, which leaves $1,380.80.
Per 2018 Circular E’s percentage method table (page 46), this employee would be taxed on wages over $509 at 12 percent plus $36.70.
Here’s a breakdown of the calculation:
$1,380.80 – $509 = $871.80 x 12 percent + $36.70 = biweekly tax withholding of $141.32
The IRS allows certain rounding procedures for figuring federal income tax withholding, such as rounding the tax to the nearest dollar. (Consult Circular E for details on this.) If you decide to use rounding, apply it in a consistent manner.
Also important is checking line 6 of the employee’s W-4 to see if he or she requested an additional withholding amount, in which case you would need to add the extra amount to the withholding amount you obtained through the percentage method.
Payroll software does all withholding calculations for you, so you may never need to manually compute employees’ federal income tax withholding via the percentage method. However, you should understand how the process works for your own knowledge or in case you are called upon to explain it.