How Are Wages Calculated on a W-2 Form?

The Form W-2, Wage and Tax Statement, is a document an employer is required to send to each employee and the Internal Revenue Service (IRS) at the end of the year. It reports an employee’s annual wages and the amount of taxes withheld from their paychecks. The figures on this form can be confusing because the final wage numbers do not always align with the total pay earned throughout the year, which is due to how taxable wages are calculated.

Identifying Your Gross Earnings

To understand your W-2, you must first identify your total or gross earnings for the year. This figure represents the entire compensation you received from your employer before any money is taken out for taxes or benefits. It is more than just your annual salary or hourly wages and includes other forms of compensation.

These additional components can include bonuses, commissions, and any overtime pay you have earned. Reported tips are also part of this initial calculation. Certain non-cash fringe benefits are considered income, such as the value of group-term life insurance coverage over $50,000 or the personal use of a company vehicle. This all-inclusive amount is the starting point for W-2 calculations, but it does not appear directly on the form.

Pre-Tax Deductions That Reduce Taxable Income

After establishing gross earnings, the next step involves subtracting pre-tax deductions. These are specific amounts withheld from your paycheck for certain benefits. The IRS allows these deductions to be taken out of your pay before calculating the federal income tax you owe, which reduces your overall tax liability.

One of the most common types of pre-tax deductions involves contributions to a qualified retirement plan. This includes deferrals to a 401(k) plan or a 403(b) plan, often found in non-profit organizations and schools. When you contribute a portion of your salary to these accounts, that money is not counted as part of your taxable income for federal purposes, and taxes are deferred until you withdraw the money in retirement.

Another category of pre-tax deductions relates to health and welfare benefits. The portion of the premium you pay for employer-sponsored health, dental, and vision insurance is deducted from your pay before taxes. Contributions made to certain health-related savings accounts also receive this favorable tax treatment.

For instance, funds you direct into a Health Savings Account (HSA) or a healthcare Flexible Spending Account (FSA) are subtracted from your gross earnings. An HSA is a savings account paired with a high-deductible health plan, while an FSA allows you to set aside money for out-of-pocket medical expenses. Contributions to a dependent care FSA, used for child or adult care expenses, also reduce your taxable income.

Calculating Your Federal Taxable Wages (Box 1)

The figure that appears in Box 1 of your W-2, labeled “Wages, tips, other compensation,” represents your federal taxable wages. This amount is calculated by taking your total gross earnings for the year and subtracting all of your applicable pre-tax deductions. This final number is what you will report as income on your federal tax return.

For example, consider an employee with annual gross earnings of $70,000. If this individual contributed $5,000 to their 401(k) plan and paid $3,000 toward their health insurance premiums, these amounts are subtracted from their gross pay. The resulting amount, $62,000, is the federal taxable wage that would be reported in Box 1 of their Form W-2.

Calculating Social Security and Medicare Wages (Boxes 3 and 5)

The wage amounts reported in Box 3 for Social Security and Box 5 for Medicare can be different from the federal taxable wages in Box 1. This is because the rules for which deductions apply to these specific taxes are not identical. While some pre-tax deductions reduce income for all three tax types, others only apply to federal income tax.

The main difference lies in the treatment of retirement plan contributions. Your elective deferrals to a 401(k) or 403(b) plan reduce your federal taxable income in Box 1, but they do not reduce your wages subject to Social Security and Medicare taxes. This makes the wage figures in Boxes 3 and 5 higher than Box 1.

Additionally, Box 3 is subject to an annual wage base limit for Social Security tax. For 2025, this limit is $176,100. Once your year-to-date earnings exceed this threshold, no further Social Security tax is withheld. Box 5, which reports wages subject to Medicare tax, has no wage base limit, so all covered earnings are reported in this box regardless of how high they are.