An illustration depicts a small business owner reviewing payroll withholding during the payroll process.

Payroll withholding: Small business guide

What is payroll withholding?

Payroll withholding refers to when an employer withholds a portion of an employee’s gross wages to pay for taxes.

As a small-business owner, you know that payroll is a vital process for your business.

From keeping your employees paid on time to ensuring that additional payments like overtime, tips, and bonuses are accounted for, you have a lot to juggle when going through the payroll process. Not only that, but you're also responsible for withholding the correct amount of wages from each of your employees' paychecks. 

This process is known as payroll withholding, and it’s crucial to ensure that both your and your employees' tax requirements are satisfied.

But how does payroll withholding work, and how can you calculate the proper amounts and deductions to withhold? Follow our payroll withholding guide to help you master the payroll withholding process.

How does payroll withholding work?

Payroll withholding is when an employer deducts a portion of their employees’ pay to satisfy legal tax requirements. While freelancers, independent contractors, and other self-employed workers must pay regular quarterly taxes, full and part-time employees of businesses do not. Instead, it’s their employer’s responsibility to pay taxes. Employers use withholdings from employees to fund this.

Payroll withholdings are considered a payroll liability for companies until they have paid their dues to the government. However, the withheld employee pay used to cover payroll taxes is not technically an expense. This expense is already accounted for in the gross pay due to employees. 

The employer is responsible for withholding, reporting, and submitting on behalf of the employee. However, employees designate how much is withheld on their Form W-4, which is usually filled out during the hiring process. 

A withholding allowance is a claim an employee can make to have less of their paycheck withheld for taxes. The more allowances a worker claims, the less money will be withheld from each paycheck.

To better understand how payroll withholding works, we’ve broken down some common payroll deduction examples.

Social Security tax

Social Security taxes fund the Social Security program, which provides financial aid to Americans who are disabled or unable to work, as well as retirees. Social Security taxes are part of FICA taxes along with Medicare taxes, which were established via the Federal Insurance Contributions Act. 

Employers must remit a portion of employee wages to pay the employee portion of Social Security tax. Note that this is in addition to the employer-paid portion of Social Security taxes.

Medicare tax

Medicare is the public program that provides reduced-cost health care to retirees who no longer receive benefits from work. Some employees may need to pay additional Medicare and Social Security taxes. This is also in addition to the employer's contribution to Medicare taxes.

Income tax

Federal income tax is withheld from employee earnings. If your state has income taxes, this also applies to state income tax. Note that your business may also owe income taxes and employee tax deductions.

State and local taxes

State and local taxes can vary greatly from state to state. Because of this, you should ensure your payroll follows all state payroll tax regulations.

Garnishments and court-ordered withholdings 

If an employee has some legal need to pay a fine or other court-mandated withholding, an employer may be required to garnish wages on their behalf. You have to comply with these orders to help the authority recover unpaid debt.

Be sure that employees always have an open line of communication to ensure that you’re withholding the right amount. For example, if an employee needs to increase their withholding for child support, it should be a simple process.

Voluntary deductions

In addition to the required common payroll deductions, employees may decide to have more money taken out of their paychecks to cover various employee benefits. Follow along as we break down some common voluntary paycheck deductions.

Health insurance 

Employees may also opt into your company-provided health benefits. If they do, then they may ask you to withhold a part of their wages to cover the employee-paid portion of the premiums. The way the responsibility for health care premiums is divided between the business and employees is up to you as the business owner.

Group-term life insurance 

Another voluntary deduction is group-term life insurance. In some cases, businesses may offer basic term life insurance to their employees for free, up to $50,000 of coverage. Employees wishing to increase their coverage or buy life insurance for a dependent may do so through post-tax deductions.

401(k) contributions 

If your business offers a 401(k) retirement plan to employees, you're responsible for withholding employees’ contributions if they choose to use it. Helping your employees prepare for retirement should be a top priority, no matter the size of your business.

Job-related expenses 

Depending on where your business is located, your employees may be able to deduct certain job-related expenses such as work uniforms or meals. Before informing your employees of this voluntary deduction, check and see if it’s offered in your state.

Now that you know the different types of payroll withholding, let’s take a look at how you can calculate payroll withholding yourself.

How to calculate payroll withholding 

Withholding payroll taxes may seem complicated, but the process is fairly straightforward. You can calculate payroll tax withholding by following these steps:

  1. Collect W-4 forms from employees: This step helps you understand how much your employees will owe in taxes. Factors such as their filing status, marital status, withholding allowances, 401(k) contributions, and insurance premiums will impact how much they owe.
  2. Withhold the funds: Next, simply withhold the calculated amount from each paycheck.
  3. Submit taxes: Be sure to pay the withheld taxes to the IRS on the schedule designated for your business; usually, this is monthly or semimonthly.
  4. Keep documentation: Always keep all payroll records and documentation, like W-4 forms, pay stubs, and tax payment receipts. You’ll need these when it’s time to file your small business taxes.

Next steps for streamlining your payroll process

Now that you know the fundamentals of payroll withholding, it's time to implement the process for your small business. Help save time and reduce human error with payroll software.

Payroll withholding FAQ

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