Mastering Payroll: How to Calculate Federal and State Tax Withholding

How to calculate federal and state tax withholding is a common question among both employers and employees. When it comes to payroll, one of the most common misconceptions is that federal and state withholdings are calculated based on fixed percentages.  

In reality, payroll tax withholdings follow a structured system of tables and brackets, designed to estimate the amount of tax an employee will owe at the end of the year. This process can sometimes lead to confusion, particularly when employees see fluctuations in their net pay. In this blog, we’ll break down how these withholdings work, what employers and employees need to understand, and key items to watch out for, including IRS lock-in letters. 

Withholding is an Estimate, Not an Exact Science 

The key thing to understand how to calculate federal and state tax withholding is that they are merely an estimate of what you will owe when you file your tax return. The IRS uses Publication 15-T, which includes detailed withholding tables that categorize income into brackets. Employers use these tables to determine how much to withhold from each paycheck based on factors such as:

• The employee’s filing status (Single, Married, Head of Household, etc.) 
• Number of dependents claimed 
• Additional adjustments specified on the employee’s W-4 form 
• The frequency of payroll (weekly, biweekly, semi-monthly, or monthly) 

Since tax liability is based on annual earnings, but withholding is done paycheck by paycheck, these calculations are never a perfect match. That’s why when employees file their tax returns, they either receive a refund (if too much was withheld) or owe additional taxes (if too little was withheld).  

Understanding IRS Withholding Tables and Brackets

Rather than applying a single rate, how to calculate federal and state tax withholding follows a bracketed system, meaning portions of income are taxed at different rates. Here’s a simplified example of how this works: 

1. A portion of an employee’s wages is tax-free due to the standard deduction.
2. The next portion is taxed at the lowest rate.
3. Additional income moves into progressively higher tax brackets, increasing the withholding amount.

How Even One Extra Dollar Can Impact Withholding

Because withholdings are determined based on tables, even earning one additional dollar on a paycheck can push an employee into a higher bracket for that pay period, increasing the amount withheld. For example: 

1. An employee earning $1,499 in taxable wages on a biweekly paycheck might have $100 withheld for federal income tax. 
2. If the same employee earns $1,500, the withholding table may dictate that $110 be withheld instead. 
3. That extra $1 in earnings** increased the withholding by **$10** due to how the payroll tax tables are structured. 

This doesn’t mean the employee is actually paying more tax overall; it’s just a temporary withholding adjustment based on the payroll cycle. When tax returns are filed, everything gets reconciled to ensure the correct amount is ultimately paid. 

Why Do Some Employees Have More or Less Withheld?

Several factors can impact how to calculate federal and state tax withholding from an employee’s paycheck, including:

• Filing Status: Different tax brackets apply based on whether an employee is filing as Single, Married, or Head of Household. 
• Multiple Jobs: If an employee has more than one job, or if both spouses work, income is combined when determining tax brackets, which may require additional withholding. 
• Bonuses and Overtime: Lump-sum payments like bonuses can sometimes result in higher withholdings, as they are often taxed at a supplemental rate. 
• State Tax Considerations: Many states have their own withholding tables that vary widely from federal calculations.

IRS Lock-in Letters: What Employers Need to Know 

One of the most critical withholding-related issues that employers should be aware of is an IRS Lock-in Letter (Letter 2800C). When the IRS determines that an employee is under-withholding (typically due to an unrealistic W-4 election), they may issue a lock-in letter instructing the employer to adjust the employee’s withholdings to a mandated level. Here’s what employers should know: 

• The employer must comply with the IRS-mandated withholding rate, even if the employee requests a change. 
• Employees have a limited window to appeal the decision. 
• Employers should not adjust withholdings back to a lower rate unless explicitly authorized by the IRS. 
• Failing to comply with a lock-in letter can make the employer liable for unpaid taxes. 

Helping Employees Make Better Withholding Decisions

As an employer, you can help employees understand their tax withholding situation by: 

1. Encouraging them to use the IRS Tax Withholding Estimator: The IRS provides an online tool that allows employees to estimate their proper withholding amount.
2. Educating Employees on W-4 Adjustments: Employees who consistently owe at year-end may need to increase their withholding, while those getting large refunds may wish to adjust their W-4 to take home more in each paycheck.
3. Providing Guidance on State Withholding Forms: Some states have their own W-4 equivalents, which may require separate adjustments.
4. Reminding Employees About Life Changes: Marriage, having children, or getting a second job can significantly impact tax liability, making W-4 updates necessary.
5. Utilizing Payroll Check Calculation Tools: Most payroll companies, such as Rabco Payroll, include a payroll check calculation tool that allows employees to test different scenarios. This can help them see the impact of various withholding choices before making changes to their W-4.

How to Calculate Federal and State Tax Withholding: Key Takeaways

Understanding how to calculate federal and state tax withholding work can help both employers and employees manage expectations when it comes to paycheck deductions and tax refunds. Federal and state withholdings are not a precise science but rather a structured estimate that gets reconciled when employees file their annual tax returns. Employers should ensure compliance with IRS guidelines, including lock-in letters, while providing employees with the necessary tools to make informed withholding choices. 

For personalized payroll guidance and to ensure compliance with tax regulations, request a consultation with Rabco Payroll today. Our experts are here to help you navigate complex payroll processes with confidence and accuracy.