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Understanding payroll tax & how to calculate it

Understanding payroll tax & how to calculate it

These days, not a lot of businesses are calculating their taxes manually anymore. It’s far simpler to use payroll software or outsource payroll to a third party instead of devoting the time and energy to do the calculations — and risk making mistakes. 

But it still helps to understand what payroll taxes are and how to calculate them accurately. It impacts businesses of all sizes, whether they have a single employee or several hundred.

Let’s unpack the basics about payroll tax, including how much it is and how to calculate it. 

What is payroll tax?

Payroll tax is a general term for all taxes paid on employees’ wages, tips, and salaries. It’s the amount withheld from employees’ paychecks each pay period as part of the payroll process, and it’s what employees owe on their own earnings.

A certain percentage of employee wages or salaries are withheld to cover federal income taxes, as well as state and local income taxes, where they’re required. 

Employers are required to withhold the employees’ share of Social Security and Medicare taxes. These two federal payroll taxes make up the Federal Insurance Contributions Act (FICA) tax. Employers also pay a share of the FICA taxes on their employee’s behalf. 

Technically, income tax and payroll tax fall into separate categories, and are listed on separate lines when reporting them to the IRS, even though they’re both payroll taxes.

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Payroll tax vs. income tax

Both payroll tax and income tax are taxes paid on money employees earn. But who’s responsible for paying them and what the federal, state, or local governments use the money for differ.  

Payroll tax refers specifically to Social Security and Medicare taxes. Both employers and employees contribute. And the amount is a flat percentage — it’s not based on the employee’s salary. 

Income tax refers to federal, state, and local income tax. Employees are solely responsible for paying their own income taxes, although the employer withholds this amount from their paychecks. 

payroll tax vs. income tax

To give you an idea of how much flows into these funds each year and what happens to the money, here are some interesting federal tax facts:

  • In 2022, 21% of the federal spending budget went to Social Security — the total bill: $1.2 trillion. 
  • Medicare costs $733 billion in 2022, or about 12.5% of the federal budget. 
  • The next-largest federal expenditures are defense ($768 billion) and economic security programs ($655 billion). 

Payroll tax rates

So, how much is payroll tax?

For payroll taxes, the rates are the same for most employees. Income tax rates may vary. 

FICA taxes

The FICA tax rate is 15.3%. The employers pay 7.65%, and the employee pays the other 7.65%. This deducts the amount owed from an employee’s wages before paying them their salary each pay period. 

Most self-employed individuals pay the full 15.3% on their own. That makes up their self-employment tax. 

Social Security tax

Of the 15.3% tax for Social Security and Medicare, 12.4% goes toward Social Security (the employees pay 6.2%, and the employer pays 6.2%).

There’s a limit to how much of an employee’s earnings can be taxed for Social Security — this impacts both employers and employees. 

For 2023, the maximum taxable earnings each year for Social Security is $160,200. That means if an employee earns $180,000 in 2023, the employee and employer both will only need to pay contributions on $160,200. 

Medicare tax

The Medicare tax is the other 2.9% of the FICA tax rate. The employees are responsible for 1.45%, and the employers cover the other 1.45%. 

While most people pay this rate, those who earn over $200,000 will pay an additional 0.9%. But only an employee pays this additional amount, not the employer. 

Federal, state, and local income taxes

Even though employers don’t contribute to the employee’s income tax contributions, they are part of the business’s payroll tax deductions, so it’s important to keep track of the tax rates. 

Unlike Social Security and Medicare tax rates, the rates for income tax will vary based on an employee’s salary and where they live.

For instance, most employees have to pay federal income taxes depending on federal withholding allowances, so a business has to withhold the appropriate amount. Keep in mind, not all states have income taxes.  

There are nine states that are considered tax-free:

  • Alaska
  • Florida
  • Nevada
  • New Hampshire
  • South Dakota
  • Tennessee
  • Texas
  • Washington 
  • Wyoming

Remote business with employees living all over the country could potentially withhold different amounts for each individual, making calculating payroll taxes extremely complex. 

In that case, payroll software might end up being a business’s new best friend. Payroll software will automatically calculate wages and tax withholdings. Most software platforms will also help deposit payroll taxes on time to the appropriate agency. 

Learn more about how BILL helps small businesses streamline their incoming and outgoing payments. 

Unemployment tax

Any business with employees must deduct the appropriate amount of their employees’ wages to pay FICA and income taxes on their behalf. They also have to pay their share of the FICA contributions. 

But that’s not all. There’s one more federal payroll tax that’s just for employers — an annual federal unemployment tax, also known as FUTA. 

FUTA stands for the Federal Unemployment Tax Act. FUTA requires employers to pay unemployment taxes for each employee. Employers pay 6% annually for the first $7,000 paid to an employee. So if a business pays an employee $15,000 annually, they will only pay 6% on the first $7,000 paid —not the full $15,000. It’s common for employers to pay this entire tax at the start of the year, unless they hire additional employees during the year. 

Then, all states have a State Unemployment Insurance Tax—SUTA (also known as SUI). This specific portion of employer taxes covers short-term benefits to employees who have lost their jobs under certain circumstances. States require employers to make quarterly payments. However, some states require the employee to pay SUI which include Alaska, New Jersey, and Pennsylvania. 

How to calculate payroll taxes

Calculating payroll taxes requires some math. Software can do the calculations automatically, but it’s still useful to know how it works. 

To calculate Social Security withholdings, multiply gross pay, minus pre-tax deductions, by the current Social Security tax rate, which is 6.2%.

Say one employee, Fred, earned $10,000 during the last pay period. So, here’s how you’d calculate this payroll tax:

$10,000 x .062 = $620

That’s Fred’s contribution. His employer would then pay $620 in payroll taxes. 

The process is the same for calculating Medicare withholdings, but using the Medicare tax rate, which is 1.45%. So, for Fred’s Medicare withholdings, deduct $145. The employer also pays $145 out of their revenue. 

$10,000 x .0145 = $145

To calculate the annual unemployment tax, multiply the gross pay by the tax rate, which is 6%, up to the first $7,000 of gross pay. So, for Fred, the total is $420 ($7,000 x .06). Once Fred has earned more than $7,000 for the year the unemployment tax will drop to $0 for the remainder of the year. 

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