How are Payroll Taxes Calculated? – Federal Income Taxable Wages

Payroll taxes can be difficult to understand, so payroll guru Matt Keller explains how they’re calculated. Read more for helpful resources.

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Understanding your W2 forms

Mark Twain once asked, “What is the difference between a taxidermist and a tax collector?”  His answer, “The taxidermist only takes your skin.” Sometimes, it can feel like we’re slowly being skinned as we see our precious earnings taken away in payroll taxes. How do we know that the amount taken for federal withholding is correct?

What Year are the Earnings Taxed?

The first step in reviewing our taxes is understanding the period in which they belong. According to the IRS, income is constructively received when an amount is credited to your account or made available to you without restriction. It is not the pay period when the work was done that determines the year, what matters is when the payment is made.


For payroll purposes, this means check date. Let’s say you’re paid on January 5, 2017, for work performed on December 16 through December 31, 2016. For IRS purposes, you’ll be taxed using 2017 withholding tables, and that paycheck should be included in your 2017 W-2.

What Income is Taxed for Federal Income Taxes?

Now that we understand period payments, the next step is learning the elements that make up federal income taxable wages from which withholding is calculated. Federal income taxable wages are determined with each paycheck and are calculated as follows:

Gross Pay (Including tips and taxable fringe benefits)

Less: Section 125 deductions (medical, dental, vision, dependent care, pre-tax commuter benefits, etc.)

Less: deferred income (401k, SIMPLE IRA, 403b, etc.)

Equals: federal income taxable wages

*Exception: Group Term Life (GTL) is a little tricky. Income is added to taxable wages for the W-2, but it’s not required to withhold federal income tax on that income.


Bob is paid semi-monthly. On this paycheck, he earned $8,000 in salary. Bob gets a semi-monthly auto allowance of $1,000. He has a medical deduction of $1,500, and he contributes 10% of his income to his 401k. What’s Bob’s taxable income for federal withholding?

*401k is calculated based on the definition of the specific 401k plan. Most plans do not include taxable fringe benefits in the calculation.

Should all Deductions Reduce Taxable Income? 

Not all deductions impact taxable income. Only those items specified by the IRS have an impact on taxes. Items such as 401k loan repayments, garnishments, company loan repayments, and union dues won’t reduce your taxable wages.

The IRS Publication 15-B – Fringe Benefits document includes a detailed chart of how specific fringe benefits are treated for tax purposes:

Now that we understand what makes up federal income taxable wages, we are ready to calculate our federal income tax withholding. We will tackle those withholding calculations in my next blog.
Want more payroll content? Check out our other Money Matters blog posts.

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