How to Withhold Using the Average Estimated Wages Method
Author: Alice Gilman
An employer must withhold federal income taxes from its employees' pay every pay period. The IRS has developed several methods employers can use to fulfill this duty. The percentage method of withholding is most commonly used by employers with automated payroll systems and third-party payroll service providers. Separate tables apply for each pay period and the marital status of employees. The percentage method tables are issued before a calendar year ends for use by employers in the following year. The IRS publishes the percentage method tables in Publication 15 (Circular E), Employer's Tax Guide.
An employer has a duty to ensure that the proper amount of income tax is withheld from its employees' pay. This may be difficult for an employer that has employees whose pay varies from pay period to pay period (e.g., employees who receive overtime pay). Income tax withholding that is based on an estimate of an employee's quarterly income, with adjustments, can bring a certain level of uniformity to an employer's withholding procedures.
Step 1: Determine the Value of an Employee's Withholding Allowance Amounts
Withholding allowances have dollar values that the IRS adjusts each year for inflation. Different withholding allowances apply to different pay periods, including an annual withholding period. An employee may claim any number of withholding allowances on Form W-4, or not claim any at all.
To determine the value of an employee's withholding allowances, an employer must multiply the value of one withholding allowance for an annual pay period by the number of allowances the employee has claimed on Form W-4.
Donna Drew is married and claims three withholding allowances on her Form W-4. Donna is paid biweekly. In 2017, the value of one biweekly withholding allowance is $155.80. The value of the three withholding allowances Donna claims is $467.40 ($155.80 × 3).
Step 2: Estimate the Employee's Quarterly Wages
An employer can use any method to estimate the amount of wages an employee will receive during the calendar quarter. An employer should take into consideration any overtime or production bonuses earned by a nonexempt employee, as well as bonuses earned by an exempt employee.
Donna earns $1,500 every biweekly pay period. During the first week of the month, she earns $373 in overtime and during the third week she earns another $350 in overtime. For the quarter, her estimated biweekly earnings are $1,620.50 ([($1,500 × 6) + ($373 + $350)] ÷ 6).
Step 3: Determine the Employee's Taxable Wages
Once the total value of an employee's withholding allowances is determined, and the employee's pay has been estimated and broken down by pay period, the employer subtracts the value of the employee's withholding allowances from his or her estimated pay to arrive at the employee's taxable pay.
Donna's estimated biweekly pay is $1,620.50 and she claims three withholding allowances. Donna's taxable income is $1,153.10 ($1,620.50 - $467.40).
Step 4: Determine Withholding Based on Estimated Wages
Employers consider the estimated wages to be actually earned and apply the appropriate percentage method table for their pay period and the employee's marital status. Once the employer determines the employee's taxable wages and marital status, the following steps apply.
- Find the appropriate taxable wage bracket on the left side of the table (Table 2 - Biweekly Payroll Period for a Married Person).
- Subtract the amount of the employee's taxable wages that exceed the figure shown in the right hand column.
- Multiply this result by the appropriate percentage.
- Add the result from Step 3 to the tax required to be withheld.
For 2017, Donna's estimated withholding for a biweekly period is $87.17, and is figured as follows:
- Looking at the percentage method withholding table for married individuals paid biweekly, the appropriate wage bracket is over $1,050 but not over $3,252.
- The amount of Donna's wages that exceed $1,042 is $103.10 ($1,153.10 - $1,050).
- Multiply $103.10 by 15%, which equals $15.47.
- Add $15.47 to $71.70, which equals $87.17.
Total withholding for a biweekly pay period is $87.17.
Step 5: Make Adjustments to the Amount Withheld
The employee's withholding should be accurate. An employer must account for additional payments the employee receives after his or her wages were estimated. An employer has 30 days to make adjustments to an employee's withholding so that the taxes withheld equal the employee's tax liability.
During the last week of a calendar quarter, Donna earns a $450 production bonus, which was not included in her estimated wages. Donna's employer must include the $450 bonus when it figures her withholding for that biweekly pay period.