What withholding methods are available?

The wage-bracket and percentage methods are the two main withholding methods used. If neither method is exactly right for your payroll situation, several alternative methods are also available. Your choice of method is generally based on the number of employees and the type of payroll system and payroll equipment you have. Tables for each method are issued annually by the IRS in Circular E, Employer's Tax Guide.

There is little difference in the tax to be withheld under any of the methods. Generally, you may change from one method to another at will, and you may use one method for one group of employees and another method for other groups.

What is the wage-bracket method of withholding? Wage-bracket withholding tables use a look-up method for withholding federal income tax. All the information necessary to determine the tax to withhold is readily available in the tables. Wage-bracket tables are provided for:

• Weekly payroll periods;

• Bi-weekly payroll periods;

• Semi-monthly payroll periods;

• Monthly payroll periods; and

• Daily or miscellaneous payroll periods.

When you use the wage-bracket tables to compute the federal income tax to withhold from a wage payment, withholding the correct amount of tax is contingent upon:

• The use of the table for the appropriate payroll period;

• The selection of the correct wage range within which the employee's gross wages fall;

• The use of the column in the tables that reflects the number of withholding exemptions the employee has claimed; and

• The use of the table that reflects the employee's marital status.

If an employee's gross wages exceed the highest amount in the wage-bracket table for the payroll period, you must use the percentage method to calculate the amount to withhold.

Computation. Three steps are necessary to compute the amount of withholding:

STEP 1: Select the table for the correct payroll period and the employee's marital status.

STEP 2: Find the amount of the gross wage payment in the far left column of the table.

STEP 3: Read across to the column headed by the number of withholding exemptions the employee has claimed.

The tables are based on the employee's gross wages. You may not deduct the employee portion of the FICA tax, employee contributions to state unemployment insurance funds, or amounts representing other forms of payroll deductions before computing the amount to withhold.

What is the percentage method of withholding? The percentage method of withholding is generally preferred by those employers using a computer for withholding purposes. However, the IRS requires use of the percentage method if an employer has a payroll period that is not covered by the wage-bracket tables. Payroll periods not covered by the wage-bracket tables include quarterly, semi-annual and annual payroll periods. The percentage method of withholding is a bit more complex than the wage-bracket method, since it requires you to compute the proper exemption value for the number of withholding exemptions the employee has claimed and the payroll period involved and to subtract that amount from the employee's gross wages before making use of the percentage method withholding tables.

Before using the percentage method tables, you will need to know the following information:

1. The employee's marital status and exemptions claimed on Form W-4.

2. The employee's payroll period. (Most employers use shorter payroll periods than the annual period. The annual value of the personal exemption must be prorated for use with shorter payroll periods.)

Computation. STEP 1: Determine the value of the employee's withholding exemptions by multiplying the value of a single withholding exemption for the payroll period by the number of exemptions claimed by the employee on Form W-4 or by using the chart above.

STEP 2: Subtract the exempt amount from the employee's total wages before deduction of any taxes or other amounts. The remainder is the amount to be used in calculating the amount to withhold.

STEP 3: Select the percentage method table that reflects the employee's payroll period and marital status. Eight percentage method tables are provided: weekly, bi-weekly, semi-monthly, monthly, quarterly, semi-annual, annual, and daily or miscellaneous payroll periods. Separate tables are provided for single and married employees.

STEP 4: Find the correct wage range in the table to calculate the amount to withhold.

The tax on that amount of wages is shown in the table as a dollar amount plus a percentage of the wages that exceed the minimum amount in the wage bracket. The dollar amount and the amount resulting from application of the percentage rate are added together to find the total amount to withhold.

Rounding. You can round off wage amounts by reducing the last digit of the gross wage amount to zero or you may compute the wages to the nearest dollar. But if you use rounding, you must use it consistently. Amounts under 50¢ should be dropped, and amounts of 50¢ and over should be increased to the next-higher dollar. Therefore, if an employee's wage is $445.37, you may treat it as a wage of $445. If the payment is $445.50, you may treat it as a wage of $446, but not as $445.

Alternative withholding methods. Alternative withholding methods augment the wage-bracket and percentage methods of withholding and are useful if you have an automated payroll system.

If these methods are not satisfactory for resolving a particular payroll problem, you may develop your own withholding procedure, so long as it yields an amount of withheld tax that is substantially similar to a specified amount. Alternative methods include:

Annualized withholding method. If you use a computer with limited memory capacity, you may choose the annualized wages method. Follow these steps to use the annualized withholding method:

STEP 1: Multiply the wages for one payroll period by the number of periods of similar length in a year to find the approximate total annual wages.

STEP 2: Compute the annual withholding tax on that amount.

STEP 3: Divide the annual withholding tax by the number of payroll periods and withhold the resulting amount for the pay period involved.

Cumulative withholding method. If payment size or frequency is irregular, cumulative withholding may be useful. This method may be used only at the written request of the employee, and only if the employee's wages since the beginning of the calendar year have been paid in payroll periods that were all of the same length. Follow these steps to use the cumulative withholding method:

STEP 1: To use this method, add the amount of wages for a particular payroll period to the total amount of wages already paid during the calendar year and divide the resulting amount by the number of payroll periods to which it applies.

STEP 2: You can then compute the tax on the average amount of wages as if the aggregate amount had been paid to the employee in each payroll period. Subtract any amounts already withheld during previous payroll periods and deduct any excess from current wages.

Quarterly averaging method. If an employee's wages for a quarter can be estimated but the size of the individual payments during the quarter is irregular, quarterly averaging may be best. If you have constant employment and little fluctuation in wages between pay periods, you may choose to withhold using an average wage payment determined by an employee's estimated quarterly wages. This method is designed so that a reasonably accurate average wage payment can be estimated. It may be used only where wages other than tips are involved, although tips may be included. Follow the steps below to use the quarterly averaging method of withholding:

STEP 1: First estimate the wages that will be paid to the employee during a calendar quarter.

STEP 2: Divide the estimate by the number of payroll periods in the quarter. The result is the average wage payment. Your withholding for any wage payment during the quarter will be based on the average payment, not on the actual payment. If the amount withheld does not coincide with the amount that would have been withheld from the actual payments, you must make an adjustment sometime during the quarter so that you withhold the proper amount of tax based on the actual payments.

Part-year employment averaging method. Seasonal industries or businesses employing a large number of students might find withholding using part-year employment averaging useful. This averaging method, which reduces the amount to be withheld, may be used for employees who work only part of the year. A written request from employees for part-year withholding is required. Part-year employment means one or more terms of continuous employment with all employers that will not total more than 245 days in a calendar year. To calculate the amount to withhold:

STEP 1: Add the wages for the current payroll period to the total wages you paid the employee for the preceding period in the current term of continuous employment. A term of continuous employment is the consecutive period the employee has worked for you during the current taxable year. The period is considered ended when the employee performs no services for you for more than 30 days. A temporary layoff of no more than 30 days does not break a term of continuous employment. However, a term is not continuous after an actual termination, even if the employee is rehired within 30 days.

STEP 2: Divide the resulting amount by the number of payroll periods covered by the employee's term of employment plus the equivalent number of payroll periods during which the employee was unemployed. The equivalent number of payroll periods is found by dividing the number of days in a current payroll period, including days off, into the number of days since the worker was last employed, up to the beginning of the current calendar year. Days for which the worker was employed during the current term of continuous employment are not included in the number of days since his employment. In determining the equivalent number of payroll periods, disregard any fraction. An employee paid for a miscellaneous payroll period is considered to have a daily payroll period.

STEP 3: Use the average amount of wages to compute the tax that would have been withheld for the number of payroll periods, using the regular withholding tables.

STEP 4: Determine the excess, if any, of the average withholding over the amount of tax withheld from the employee's wages for the current term of continuous employment. Withhold this amount.

Substantially similar withholding methods. Employers can develop their own withholding methods by using the following guidelines. However, your system must result in withholding amounts that are substantially similar to amounts determined by using the percentage method for the payroll period involved. Under the IRS withholding regulations, only the percentage method tables provide the norm, and the substantially similar test is defined as an amount not greater than the maximum permissible deviation from the percentage method amount. To determine whether an alternative method results in substantially similar withheld amounts, the wages must first be annualized and the annual withholding determined from the annual percentage method tables. An amount that is within $10 of the amount required under the percentage method tables will be considered substantially similar, as shown in the table below.

Employers can develop their own withholding methods by using the following guidelines. However, your system must result in withholding amounts that are substantially similar to amounts determined by using the percentage method for the payroll period involved. Under the IRS withholding regulations, only the percentage method tables provide the norm, and the substantially similar test is defined as an amount not greater than the maximum permissible deviation from the percentage method amount. To determine whether an alternative method results in substantially similar withheld amounts, the wages must first be annualized and the annual withholding determined from the annual percentage method tables. An amount that is within $10 of the amount required under the percentage method tables will be considered substantially similar, as shown in the table below.

All methods must be thoroughly tested to ensure that they meet the standard.

Withholding methods used. The wage-bracket and percentage methods are the two main withholding methods used. If neither method is exactly right for your payroll situation, several alternative methods are also available. Your choice of method is generally based on the number of employees and the type of payroll system and payroll equipment you have.

There is little difference in the tax to be withheld under any of the methods. Generally, you may change from one method to another at will, and you may use one method for one group of employees and another method for other groups.