How Paycheck Withholding works   Leave a comment

Some people are misinformed about how paycheck withholding works. Today I’ll discuss two common misconceptions:

  • Overtime pay is taxed at a higher rate
  • Bonuses are taxed at a higher rate

Just so we’re all on the same page: every time you get a paycheck, unless you’ve set it up otherwise, there are federal and state taxes withheld (if your state actually has an income tax). This is because in reality, you are supposed to pay your taxes periodically throughout the year, as opposed to all at the end.

When you first start working at a new job, you are always required to fill out a W-4. On this W-4, you are asked to claim a certain amount of allowances. Every allowance you claim reduces the taxes withheld from your paycheck.

Here’s the key point that many people don’t seem to understand: for every paycheck, taxes are withheld assuming that you will be paid at that rate for the entire year.

Suppose you get paid $26 an hour, biweekly. You work 40 hours a week, so the gross pay on your standard paycheck is $2080. Also suppose that you’ve claimed the correct amount of allowances such that you will have a tax refund of zero if you work 40 hours a week for 50 work weeks (standard work year). Your federal tax bill on this will be $6218.75, for an average tax rate of 11.96%. Hence, you will have 2080*.1196 = $248.77 withheld in federal taxes

But suppose you work 10 hours of overtime one week. Overtime is paid at 1.5x your normal rate, so you get an extra $390 on your next paycheck. The gross earnings on your next paycheck is $2470. Now remember, tax withholding assumes you will earn at this rate for the entire year. So it will withhold tax assuming you earn $2470*26 = $64220. If you did actually earn this amount, then your federal tax bill would be $9273.75, for an average tax rate of 14.4%. Hence, you will have $355.68 withheld in federal taxes.

So on this paycheck with overtime pay, you will have a higher percentage of your paycheck withheld for federal (and state if applicable) income tax. However, that doe not mean overtime pay or bonuses are taxed at a higher rate. They are all treated as income, just like everything else. Withholding gives the impression that it is taxed at a higher rate, when that’s just a byproduct of how withholding works.

If you don’t believe me, check your W-2 statement from your employer. If overtime pay or bonuses were truly taxed at a higher rate than standard income, then there would have to be a special box for it on your W-2. Such a box does not exist.

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Posted January 29, 2015 by Fiby in Uncategorized

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