The Basics of Payroll Tax Withholding

To employees, payroll may seem pretty straightforward. Employers, on the other hand, know how complicated payroll can get, especially when it comes to withholding taxes.

To make payroll a little less daunting, this blog covers what you need to know about withholding, including how it differs from deductions and some special cases to consider—such as bonuses, commissions, and other supplemental wages. 

The Difference Between Withholdings and Deductions

There’s a lot to keep in mind when setting up and running payroll, but the real challenge is determining how much to withhold and deduct. 

While the terms are often used interchangeably, withholdings and deductions are not the same thing. Simply put, taxes are withheld, and benefits are deducted.

Payroll tax withholding includes federal, state, and sometimes local income taxes, Social Security taxes, and Medicare taxes. Social Security and Medicare are often collectively called FICA taxes—which refers to the Federal Insurance Contributions Act, the legislation that requires employers to withhold those taxes from their employees’ paychecks. 

Taxes, premiums, and contributions are typically taken out of employees’ paychecks in three stages:

1. First, subtract the total amount of health plan and life insurance premiums, HSA and 401(k) contributions, and other pre-tax deductions from gross pay.
2. Next, calculate how much income and FICA tax to withhold from each employee’s paycheck based on how they completed Form W-4. To be clear, these taxes only apply to the amount of gross pay minus pre-tax deductions. The IRS website has a Tax Withholding Estimator to help with these calculations.
3. Finally, subtract the total amount of all post-tax deductions, such as Roth IRA contributions, disability insurance premiums, and union dues. Court-ordered wage garnishments for child support, outstanding tax obligations, and debt repayments are also subtracted after taxes.

What Employers Need to Know About Payroll Withholding

As mentioned, employees determine how much employers should withhold from their paychecks by filling out Form W-4. New hires usually complete this form during onboarding, but employees should update their W-4 anytime they experience a life event that could affect their tax situation.

For 2025, the Social Security tax rate is 6.2% up to $176,100 for employees. Wages above that are not subject to Social Security taxes. The same rate and limit apply to employers as well. So, to clarify, employees and employers together pay a 12.4% payroll tax for Social Security.

Medicare is calculated differently. The Medicare tax rate is 1.45% for employees and 1.45% for employers with no wage limit. In fact, there is an added 0.9% tax on employee income above $200,000 (for single filers) and $250,000 (for married, joint filers).

Of course, state withholding requirements vary by state, and remote workers out of state present even more tax withholding complications.

How to Withhold Taxes from Supplemental Wages

The IRS classifies bonuses, commissions, severance, non-qualified stock option exercises, and vesting of restricted stock units as “supplemental wages” and taxes them differently.

The IRS outlines two ways employers can calculate withholding taxes on supplemental wages:

• The Percentage Method

The percentage method is also called the flat rate method, and it’s the more popular of the two with employers since it’s much easier to calculate.

Essentially, in the percentage method, supplemental wages are run as a separate payroll. In most cases, there is an additional expense to running an additional payroll, but employers tend to prefer this simpler method in spite of the extra cost. This is also why so many organizations limit how frequently they pay out bonuses, commissions, and the like.

In 2025, the federal withholding rate for supplemental wages is 22% up to $1 million. Any supplemental wages over $1 million are taxed at 37%. To be clear, the $1 million threshold does not include a regular salary income.

Again, states tax supplemental wages at different rates, so be sure to consult with an accountant for your specific situation.

The major drawback to the percentage method is for highly compensated employees. Their tax liability may be greater than their withholdings, which could lead to a surprise bill during tax season.

• The Aggregate Method

The alternative for calculating withholding taxes on supplemental wages is called the aggregate method.

Using this method, the employer combines an employee’s regular and supplemental wages into their gross pay for a pay period and withholds taxes based on the employee’s W-4. The employer only has to run one payroll, but it can be much more complicated for employers to calculate. 

The aggregate method tends to be more accurate than the percentage method but can still lead to an employer withholding too much. So, a tax refund would be more likely than a tax bill, but of course, that means a smaller paycheck for employees up front.

Additional Resources

You can stay informed, educated, and up-to-date with important HR topics using BerniePortal’s comprehensive resources:

• BerniePortal Blog—a one-stop-shop for HR industry news
• HR Glossary—featuring the most common HR terms, acronyms, and compliance
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• BernieU—free online HR courses, approved for SHRM and HRCI recertification credit
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