Payroll Withholding

Payroll preparation is more complex than multiplying an employee's hours worked by the rate of pay. Federal laws and state laws require certain types of mandatory payroll deductions, or payroll withholding. Lack of adherence to these laws can have severe repercussions.

Federal income tax withholding is based on how an employee completes Form W4. A W4 form must be completed at the time of hire and includes the employee's name, address, Social Security number and the number of dependents to claim, filing status, multiple jobs or spouse income. Claiming more dependents equates to less withholding, resulting in a larger take home pay for the employee. Adversely, claiming fewer dependents causes an increase in withheld dollar amounts, creating a decrease in the employee's paycheck. An employee may choose this option to increase the amount of his or her annual federal tax return.

Employees can use the Tax Withholding Estimator from the IRS to determine how their withholding affects their refund, take-home pay or tax due.  

Another type of federally imposed deduction is FICA tax, or Federal Insurance Contributions Act tax. FICA tax was introduced in the 1930s as a way to pay for the newly formed Social Security program. In the 1960s, the government introduced Medicare and increased the FICA tax to cover its cost. Half of the FICA tax is collected from employee payroll withholding, while the other half is the employer's responsibility.

In addition to federal taxes, most states also impose taxes on an employee's income. These taxes are determined by employee information provided on a state W4 form. Employers are required to withhold these funds from the employee's payroll and submit the amounts to the state at regular intervals, usually quarterly forms. States may also require withholding for court ordered child support payroll deductions.

An employee can choose to have additional monies withheld from his or her payroll. Premiums for life insurance, medical insurance and dental insurance can all be deducted from an employee's pay. Child and elder care expenses can be withheld, as can retirement plan investments and contributions to employee health care accounts. Signed approval forms must be completed to legally make optional deductions.

While there are no repercussions for not withholding optional deductions, failure to adhere to federal and state tax requirements can cause serious problems for a small business owner. Fees will be imposed, interest will be charged on unpaid balances, and unresolved accounts can eventually lead to jail time. Small business owners should carefully research federal and state payroll withholding and filing requirements and procedures before starting the hiring process.