Payroll Withholdings: Taxes & Benefits Paid by Employees
This section of payroll accounting focuses on the amounts withheld from employees' gross pay. (In Part 4 of payroll accounting we will discuss the payroll taxes that are not withheld from employees' gross pay.)
The U. S. income tax system—as well as most state income tax systems—requires employers to withhold payroll taxes from their employees' gross salaries and wages. The withholding of taxes and other deductions from employees' paychecks affects the employer in several ways: (1) it reduces the cash amount paid to employees, (2) it creates a current liability for the employer, and (3) it requires the employer to remit the withheld taxes to the federal and state government by specific deadlines. Failure to remit payroll taxes in a timely manner results in interest and penalties levied on the employer; flagrant violations trigger more severe consequences.
Payroll withholdings include:
- Employee portion of Social Security tax
- Employee portion of Medicare tax
- Federal income tax
- State income tax
- Court-ordered withholdings
- Other withholdings
1. Employee portion of Social Security tax
A key component of payroll accounting is the Social Security tax. (The Social Security tax along with the Medicare tax make up what is referred to as FICA.) Social Security tax is withheld from an employee's salary or wages and the employer is also required to pay a Social Security tax. In other words, the employer is responsible for remitting to the federal government both the employee and the employer portions of the Social Security tax. As a result, Social Security tax is both an employee withholding and an employer expense. (The official title for the system financed by the Social Security tax is Old Age, Survivors and Disability Insurance, or OASDI. As the name indicates, this system pays retirement, disability, family, and survivors' benefits.)
In 2018, the amount of Social Security tax that an employer must withhold from an employee is 6.2% of the first $128,400 of the employee's annual wages and salary; any amount above $128,400 is not subject to Social Security tax withholdings. For example:
- If an employee earns $40,000 in wages in 2018, the entire $40,000 is subject to withholdings at 6.2%, for a total annual withholding of $2,480.
- If an employee earns $200,000 in salary in 2018, only the first $128,400 of the salary is subject to the Social Security tax of 6.2%, for a total annual withholding of $7,960.80. (The amount of salary that is greater than $128,400 is not subject to Social Security tax withholdings, although it will be subject to the Medicare tax discussed in the next section.)
The amount withheld—and the employer's portion—are reported as a current liability until the amounts are remitted to the government by the employer.
Note: The employee's tax rate for Social Security and the amount subject to the tax can be found at http://www.irs.gov/pub/irs-pdf/p15.pdf.
2. Employee portion of Medicare tax
Medicare tax is also withheld from an employee's salary or wages and the employer is also required to pay a Medicare tax. In other words, the employer is responsible for remitting to the federal government both the employee and the employer portions of the Medicare tax. As a result, Medicare tax is both an employee withholding and an employer expense. (The Medicare program helps pay for hospital care, nursing care, and doctor's fees for people age 65 and older as well as for some individuals receiving Social Security disability benefits.)
The combination of the Social Security tax and the Medicare tax is referred to as FICA (an acronym for Federal Insurance Contribution Act).
An employer must withhold 1.45% of each employee's annual wages and salary for Medicare tax. Unlike the Social Security tax, this percentage is applied on every employee's total salary no matter how large the salary might be—an employee's salary of $200,000 will require Medicare tax withholdings of $2,900 (the entire $200,000 times 1.45%).
Also, there is a Medicare surtax of 0.9% that is withheld from the employee on wages and salaries that are in excess of certain amounts. See IRS.gov for detail on this surtax.
The employee's Medicare tax withholding plus the employer's Medicare tax are reported as a current liability until the amounts are remitted to the government by the employer.
3. Federal income tax
Another part of payroll accounting involves the employees' federal income tax. An employer is required to withhold the federal income tax that an employee is expected to owe based on salaries or wages. The amount withheld, however, is rarely the exact amount of income tax that the employee will owe to the government. The employee's year-end income tax return will dictate the exact amount owed for the year, meaning the employee will either pay in a little more in taxes, or will receive a tax refund.
The amount withheld for federal income tax is based on the employee's salary or wages as well as personal information that the employee is required to provide the employer on federal form W-4. In cases where an employee is paid low wages, it may not be necessary for the employer to withhold any federal income tax. Unlike FICA, there is no employer contribution for federal income tax.
Amounts withheld from employees for federal income taxes are reported on the employer's balance sheet as a current liability. When the employer remits the amounts to the federal government, the current liability is reduced.
4. State income tax
In most states payroll accounting will involve a state income tax. In those states an employer is required to withhold the state income tax that an employee is expected to owe based on salaries or wages. Like its federal counterpart, the amount withheld is rarely the exact amount of income tax that the employee will owe to the state government. (It should be noted here that some states do not levy a personal income tax.)
The amount withheld for state income tax is based on the employee's salary or wages as well as personal information that the employee is required to provide the employer on a state version of federal form W-4. In cases where an employee is paid low wages and/or has a large number of personal exemptions, it may not be necessary for the employer to withhold any state income tax. Like the federal income tax (and unlike the FICA tax), there is no employer contribution for state income tax.
Amounts withheld from employees for state income taxes are reported on the employer's balance sheet as a current liability. When the employer remits the amounts to the state government, the current liability is reduced.
5. Court-ordered withholdings
Payroll accounting also involves withholdings for items other than payroll taxes. For example, courts of law may order employers to garnish (withhold money from) an employee's salary or wages for purposes such as paying child support or repaying debts.
The amounts withheld from employees for court-ordered withholdings are reported on the employer's balance sheet as a current liability. When the employer remits the amounts to the designated parties, the liability is reduced.
Some court orders may include a small fee to be withheld from the employee in order to reimburse the employer for administrative expenses. For example, the court order might direct the employer to withhold $101 from the employee and to remit $100 to a designated agency. The $1 difference will be a credit to the company's administrative expenses or to a miscellaneous revenue account.
6. Other withholdings
In addition to the mandatory withholdings that an employer makes for taxes and court orders, payroll accounting often includes amounts that employers may be willing to withhold at the direction of its employees. These voluntary withholdings can include such things as:
- union dues
- charitable contributions
- insurance premiums
- 401(k) and 403(b) contributions
- U.S. savings bonds purchases
- payments owed to the company for the purchase of company merchandise
If the voluntary withholdings are to be remitted to places outside of the company (a local charity, for example), the amounts withheld are reported on the employer's balance sheet as a current liability. When the employer remits the withholdings, the current liability will be reduced.
If the withholdings are for amounts that are due the company (such as employees' share of insurance premiums or amounts owed by employees for company merchandise), no remittance is required. Rather, the journal entry reflects a credit that reduces the company's insurance expense or reduces the company's receivables from employees. Sample journal entries are provided in Part 5 and Part 6.
Net pay is the amount that remains after withholdings are deducted from an employee's gross pay. Net pay is also referred to as "take home pay" or the amount that an employee "clears." From the company side of the transaction, it is the amount of cash the company will pay directly to the employees on payday.