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Basics of Payroll Taxes

By Jeannine Mancini

Published on 6 Mar 2023 6 min read

Payroll taxes: they’re like the vegetables of the business world. They may not be the most exciting or glamorous aspect of running a company, but they’re essential for keeping things running smoothly. Just like you need your greens for a healthy diet, you need to understand the basics of payroll taxes for a healthy business.

What Are Payroll Taxes?

Payroll taxes are a type of taxation that is taken out of an employee’s wages or salary before it is given to them. This money goes towards funding various social programs such as Medicare, Social Security, and unemployment insurance. It is usually paid by both the employer and the employee in some form; for instance, the employer might pay 6.2% of the employee’s wages towards Social Security, while the employee pays 4.2%. 

Payroll taxes also include certain local taxes that fund state disability insurance and other programs. The exact payroll tax rate varies from one geographical location to another and can be different for employees who work for organizations with multiple locations or on different projects. In general, these taxes are used to support public welfare programs and fund government operations, so they are an essential part of maintaining a functioning economy.

Payroll Tax Categories

Understanding the various payroll withholding categories is essential for employers and employees alike to ensure accurate calculations and compliance with tax laws.

Federal Tax

Federal taxes refer to the taxes imposed by the federal government to generate revenue for public services, such as national defense, infrastructure, and Social Security. 

Federal tax is usually a combination of income, payroll, and corporate taxes. The federal tax withholding rate for payroll depends on several factors, including the employee’s taxable income, filing status, and the number of allowances claimed on their W-4 form. 

Social Security Tax

The Social Security tax withholding rate from paychecks is 6.2% of the employee’s gross wages. For example, if an employee earns $50,000 in gross wages in a year, they will have $3,100 withheld from their paycheck for Social Security taxes (50,000 x 0.062 = 3,100). 

This rate applies to all employees regardless of age or income level up to a certain wage cap set by the Internal Revenue Service (IRS). Any wages over the wage cap are not subject to Social Security withholding and thus are not eligible for Social Security benefits at retirement. Employees can check their total Social Security taxes withheld each year on their W-2 form.

Medicare Tax

The Medicare Tax rate is 1.45% for both employers and employees under the Federal Insurance Contributions Act (FICA) tax rules. This amount is taken out of each employee’s paycheck before it is given to them so that it can be put towards funding Medicare services. Employers must also match this amount when paying out an employee’s wages or salary for their employees to receive full benefits when they become eligible for Medicare coverage in retirement age. 

Additional Medicare Tax

The Additional Medicare Tax is a payroll tax for employers and employees that applies to employees’ wages, compensation, and self-employment income above a certain threshold. The Additional Medicare Tax is 0.9%, half of which is withheld from the employee’s paycheck, while the other half is paid by the employer.

Federal Unemployment (FUTA) Tax

Federal Unemployment (FUTA) Tax for payroll is an unemployment tax that employers must pay on the first $7,000 in wages paid to each employee during the year. The FUTA rate for 2021 stands at 6%. A sample computation would be if an employer pays an employee $5,000, then that employer must pay a FUTA tax of $300. 

State Unemployment Tax

State unemployment tax is a tax that employers must pay to their state to help fund unemployment benefits. This tax usually ranges from 1%-8% of the total wages paid to employees and like FUTA taxes, it applies to only the first $7,000 in wages per employee during the year. In addition, some states may offer credits or reduced rates based on factors such as how low your company’s experience rating is or whether you have participated in state-sponsored training programs for your employees. 

State or Local Tax

State or local taxes are levied by states or local governments on income earned by individuals or businesses located within their jurisdiction. These taxes are typically assessed based on where you live or work and include income taxes as well as sales, property, and other taxes. Examples of these taxes include state income taxes, local sales taxes, real estate transfer fees, and property taxes. Depending on where you live and work, there may be multiple layers of taxation involved, which can get quite complex especially when dealing with businesses operating across multiple jurisdictions.

Taxable Income

Taxable income for payroll is the total amount of an individual’s wages, salaries, tips, and other forms of earnings that are subject to taxation by the federal government during a given tax year. This includes compensation received from any job, as well as certain types of investment income and rental property income. Taxable income is typically determined by subtracting all valid deductions and credits from the individual’s gross income for a tax year. 

Calculating Payroll Taxes

The employer is responsible for calculating the payroll taxes for each employee, which includes federal income tax, Social Security tax, Medicare tax, and state and local income taxes if applicable. This is done by calculating the wages earned by each employee and then applying the proper tax rate to those wages. The employer must also determine the total amount of taxes that must be withheld from the employees’ paychecks and collected on their behalf. Depending on where they are located, employers may have to calculate additional payroll taxes as well.

For federal income tax withholding, employers use tables published by the IRS to determine how much should be withheld from each employee’s paycheck based on their filing status and wages earned. Similarly, Social Security and Medicare taxes are calculated using the Social Security Administration’s wage base limit as well as other factors such as marital status and the number of exemptions claimed. State and local income taxes may also need to be calculated depending on state laws or any local ordinances in effect. 

Calculating payroll taxes can be a challenging task due to the complexity and changing regulations. Employers should ensure that they remain up-to-date with all regulations surrounding payroll taxes to accurately calculate withholding amounts for their employees.

Withholding Taxes from Employees

Withholding taxes from employees is a crucial responsibility for employers. It’s the process of deducting a specific sum of money from each employee’s salary to cover their federal, state, and local tax obligations. This amount is then transferred to the IRS on behalf of the employee. In some cases, employers are even required to withhold additional taxes other than income or payroll taxes such as unemployment insurance and Medicare contributions. 

Withholding taxes helps ensure that employees pay their obligations in full and on time to avoid any penalties or fees associated with non-payment or late payments. 

Filing and Paying Payroll Taxes

Employers are responsible for remitting the taxes withheld from employee paychecks to the appropriate tax authorities regularly. This typically involves making monthly or quarterly payments, depending on the employer’s size and tax liability. Employers must also file various tax forms to report the taxes withheld and paid on behalf of their employees.

Failure to withhold and remit taxes properly can result in penalties and interest charges. Therefore, employers need to stay on track with their tax obligations and ensure compliance with all applicable tax laws.

Keeping Records of Payroll Taxes

Employers must also keep meticulous records of all deductions made from employee paychecks to accurately report these figures to the IRS at the end of each tax year. Withholding taxes can be an administratively burdensome task for employers, but it is an essential part of properly managing payrolls and helping employees meet their tax obligations.

A Necessary Part of the Business

Payroll taxes can be a complex and ever-changing aspect of running a business. Employers are responsible for accurately calculating and remitting taxes on behalf of their employees, which requires a solid understanding of federal, state, and local tax laws, as well as the various withholding categories.

Properly managing payroll taxes and keeping accurate records is crucial for any business. Count on doola to help ensure that your business is compliant with tax laws. 

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