Part of being an employer is withholding taxes from your employees’ wages before giving them their paychecks. That’s why you need to understand taxable wages before you run payroll.
Remember how surprised you were when you saw the chunk of cash taken out of your first paycheck for Uncle Sam? Fortunately for workers, not all wages are taxable.
What are taxable wages?
Taxable wages are employee earnings that are subject to taxation. Types of compensation that are subject to taxation include:
- Salaries or hourly wages
- Overtime wages
- Severance pay
- Accrued time off payouts
- Employee stock options
- Some fringe benefits
So, what types of taxes apply to taxable wages? Taxable wages are subject to income, Social Security, Medicare, FUTA (federal unemployment), and SUTA (state unemployment) taxes. It might also be subject to state-specific taxes, like the Oregon transit tax. So, who pays taxes?
|Employee-only Taxes||Employer-only Taxes||Employee & Employer Taxes|
|Federal income tax||FUTA tax||Social Security tax|
|State income tax||SUTA tax*||Medicare tax|
|Local income tax||SUTA tax* (AK, NJ, & PA)|
Employees, employers, or both are responsible for paying taxes. As an employer, you are responsible for remitting taxes to the appropriate agencies.
You must also report an employee’s taxable wages on the W-2 form. In fact, Form W-2 has separate boxes for reporting taxable wages subject to federal income, Social Security, and Medicare taxes.
Why is that? Some wages are only subject to certain taxes. For example, federal taxable wages may differ from Medicare taxable wages and FUTA taxable wages. Read on to learn why and how you can calculate your employees’ wages that are taxable.
3 Things to know about taxable wages
Not all wages are taxable. Before withholding or paying taxes on an employee’s compensation, ask yourself the following three questions:
- Has the employee earned above the taxable wage base?
- Does the employee have any pre-tax deductions?
- Are the earnings taxable in the first place?
To avoid making a costly mistake when calculating taxable wages, keep the following three things in mind.
1. Some taxes have a taxable wage base
There are specific limits on the amount of taxes the government can demand from employees—for some taxes.
The taxable wage base is the highest amount of wages employees or employers pay taxes on. Once an employee earns more than a tax’s annual wage base, their wages are no longer subject to that tax.
So, which taxes have a taxable wage base? These are the types of taxes that limit an employee’s taxable wages (if they earn above the wage base):
- Social Security tax
- FUTA tax
- SUTA tax
- State-specific taxes
Use the chart below to find out what the wage base is for each type of tax:
|Social Security tax||$160,200 (2023)|
Any wages that an employee earns after the wage base are no longer taxable wages for that type of tax.
For example, stop paying FUTA tax once an employee earns more than $7,000. But, the employee’s wages are still subject to other taxes.
2. Pre-tax contributions lower taxable wages
There are some types of deductions that reduce an employee’s taxable income. These are known as pre-tax deductions.
When you figure taxable wages, deduct pre-tax contributions from an employee’s gross pay before computing taxes.
So, what are pre-tax deductions? Some examples of pre-tax deductions include retirement plan contributions, education reimbursements, life insurance plan contributions, health insurance premiums, and HSA and FSA contributions.
Keep in mind that many pre-tax contributions have a limit. This limit determines how much money is tax-exempt during a calendar year. For example, only the first $5,250 of educational assistance is tax-exempt.
3. Some types of compensation are nontaxable, period
Most wages you pay employees are taxable. But, some forms of compensation are not generally considered taxable wages.
Nontaxable wages may include business expense reimbursements (if they follow IRS rules), certain non-cash holiday gifts for employees (e.g., turkeys during holidays), and cash advances or loans.
Consider consulting a tax professional about which of your employee wages are nontaxable.
How to calculate taxable wages
So, how do you calculate taxable wages? You must calculate your employees’ gross wages, deduct any pre-tax contributions, and be mindful of taxable wage bases.
To calculate an employee’s gross earnings, simply multiply their hours worked during a pay period by their hourly rate.
Once you know the employee’s gross pay, deduct pre-tax contributions to arrive at their taxable wages.
Let’s say you have an employee who earns $20 per hour and works 40 hours. The employee’s gross wages are $800 ($20 X 40 hours). The employee has $50 in pre-tax deductions. This makes the employee’s taxable wages $750 ($800 – $50).
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This article has been updated from its original publication date of January 11, 2016.This is not intended as legal advice; for more information, please click here.