Payroll Taxes: Definition, Process, and Calculation

As an employer, you’re often responsible for applying government tax rates to the money an employee earns. This involves withholding taxes from an employee’s earnings. Then, your company pays that withheld money to the government on behalf of the employee.

Handling employee contributions to the tax man can get complicated. That’s especially the case when you combine the need to pay federal taxes with those due to local governments. This article digs into what payroll deductions mean in relation to taxes and what you can do to ensure you handle payroll taxes properly.

Table of Contents

What Are Payroll Taxes?

Who Pays Payroll Taxes?

How Payroll Taxes Work

How to Calculate Employer Payroll Taxes

Payroll Tax Withholding Example

Key Takeaways

FAQs on Payroll Taxes

What Are Payroll Taxes?

Payroll taxes refer to any money deducted from employee paychecks to pay for essential services. 

These taxes break down into several categories. For example, the United States has payroll taxes to fund its Social Security and Medicare programs. These types of income taxes ensure people have access to basic benefits. They serve as a type of unemployment insurance, in addition to giving people access to basic medical care.

Other payroll taxes include federal income tax. The money raised from this goes into the government’s general fund, which the U.S. Treasury controls.

Finally, many states, cities, and counties apply income taxes separately. Employers must also deduct these taxes from employees’ paychecks.

Payroll taxes made up 36.6% of all federal tax revenue in 2021. As such, they’re vital for keeping the country running efficiently.

Who Pays Payroll Taxes?

On the surface, it may seem like employees pay these types of taxes. After all, the money comes out of each employee’s pay. The taxes are also reflected on the employee’s pay stubs.

But it’s not quite that simple.

Even though payroll taxes come from the employee’s salary, they’re not responsible for actually paying the taxes. Instead, an employer withholds the money and pays it to the relevant government authority on behalf of the employee.

In this sense, the employer acts as an agent on behalf of the government. The employer collects taxes from employees’ wages and ensures those taxes go to the right people.

However, you also have to account for an employer’s share of some of these taxes. Under the Federal Insurance Contributions Act (FICA), employers must match their employees’ contributions to FICA taxes. Social Security and Medicare taxes fall into this category. In this case, the money employers pay counts as a business expense. That means they can write their contributions off when filing business taxes.

How Payroll Taxes Work

We can break payroll taxes down into several categories. Your company has to understand each category to meet its payroll tax responsibilities.

Social Security Tax

Social Security tax applies to any money paid to the general government that it uses to provide a future benefit. Such benefits include:

• Unemployment insurance
• Benefits related to accidents, injury, or sickness
• Pensions
• Reimbursement for hospital expenses

Employers withhold a set percentage from their employees’ salaries to pay this tax. Furthermore, the employer pays an equal percentage under FICA guidelines.

The current Social Security tax rate is 6.2%, which applies to both the employer and the employee. This creates a challenge for self-employed people, as they must pay 12.4% in taxes because they’re both a business and an employee.

A maximum salary cap of $147,000 applies to the Social Security tax. Both employee and employer contributions stop upon reaching this cap.

Medicare Tax

Like Social Security tax, both the employer and the employee contribute to Medicare taxes. The current rate is 1.45%, creating a total tax obligation of 2.9% with the employer contribution.

This money funds Medicare, which is a federal health insurance program. Medicare provides coverage to people aged 65 or over. It also covers some younger people with certain disabilities, in addition to those with end-stage renal diseases.

A wage base limit of $147,000 applies to Medicare contributions.

Federal Income Tax

Federal income tax is a little more complicated than the FICA taxes. There are seven percentage tiers to consider. What applies to an employee depends on how much they earn per year. The brackets for single people in 2024 are as follows:

• 10%: $0 to $11,600
• 12%: $11,601 to $47,150
• 22%: $47,151 to $100,525
• 24%: $100,526 – $191,950
• 32%: $191,951 to $243,725
• 35%: $243,726 to $609,350
• 37%: $609,351 or higher

Note that this is a marginal tax rate. This means you apply the rate solely on the income that falls into that range. Also, the rates differ if your employee files their taxes jointly.

For example, let’s assume an employee earns $30,000 per year. In this case, you apply the 10% rate to all money earned up to $10,275. From there, you apply the 12% rate to the rest of the employee’s income. If their wage rises to $50,000, you will apply the 22% rate to earnings above $41,755, with the lower rates applying elsewhere.

State and Local Income Tax

The FICA and federal income taxes apply to all employers. Things get a little more complicated when you take local and state income taxes into account.

Currently, only seven states don’t apply any sort of local tax on income: Alaska, Nevada, Florida, Texas, Wyoming, Tennessee, and South Dakota.

Some states have a flat income tax rate. This means they apply the same rate to all incomes, regardless of how high or low that income is. The states with a flat rate are as follows:

• Colorado
• Indiana
• Kentucky
• Illinois
• Massachusetts
• Michigan
• Utah
• Washington
• Pennsylvania
• New Hampshire
• North Carolina

Furthermore, there are variations in how the above states apply their flat rates. New Hampshire only taxes income from dividends and interest, which means employers often don’t have to worry about this state tax. Washington only applies its state income tax to the capital gains of high earners.

The rest of the states in the union have a graduated-rate income tax. This works the same way as federal income tax does in terms of having set tax brackets.

It gets more complicated.

Some cities apply taxes beyond state taxes. For example, San Francisco levies a 0.38% income tax on top of state and federal income taxes. Similarly, Wilmington in Delaware has a 1.25% tax on income. As a consequence, you may have to apply these taxes when working on your income tax withholding calculations.

A final complication comes in the form of varying tax rates. Each state has different rules, which you need to understand before making your calculations. It may be a good idea to speak to a financial advisor to ensure you handle state employment taxes correctly.

Federal Unemployment Tax

The Federal Unemployment Tax Act (FUTA) states that employers must pay a tax that funds unemployment systems.

These systems offer support to people who lose their jobs. If an employee loses their job, they can claim unemployment benefits designed to help them until they find another job.

The majority of employers pay both federal and state unemployment taxes. But these taxes aren’t deducted from employee paychecks. Instead, employers have sole responsibility for paying this tax.

For this reason, it may appear that the FUTA tax isn’t a payroll tax. But that isn’t the case. The amount the employer pays depends on an employee’s wages, making FUTA a payroll tax. Currently, employers only pay federal unemployment taxes up to a fixed threshold of $7,000 per employee.

Some employers may also claim a credit against their FUTA tax obligations. This usually applies if the employer had to pay into a state unemployment fund. The credit varies depending on the state.

How to Calculate Employer Payroll Taxes

Calculating payroll taxes can get complicated as you need to satisfy all of the above categories. Small business owners may find the calculations challenging when trying to account for all of their employees. The following steps help when figuring out how much an employer needs to withhold and pay in payroll taxes.

Step 1: Calculate FICA Taxes

FICA taxes include the taxes paid for Social Security benefits and Medicare.

Start with Social Security.

Multiply the employee’s gross pay for the relevant pay period by the current Social Security tax rate of 6.2%. Withhold this amount from the employee’s pay. Furthermore, match the figure to reach the 12.4% rate.

Do the same with Medicare tax. Multiply the employee’s gross pay by the current 1.45% rate. Withhold this amount while also matching it with your own contribution.

Step 2: Calculate Federal Income Tax

Assuming the employee files their taxes using Form W-4, you can calculate how much federal income tax to withhold by doing the following:

• Locate the worksheet titled “Wage Bracket Method Tables for Manual Payroll Systems With Forms W-4 From 2020 or Later.” It’s in IRS Publication 15-T.
• Check Form W-4 to see if the employee files taxes jointly or individually.
• Enter the employee’s total taxable earnings on line 1a of your worksheet.
• Record the number of pay periods on line 1b.
• Input the amount your employee enters in Step 4a of their Form W-4 on line 1c. Then, divide this number by the number of pay periods and write that number in line 1d.
• Add the sum of lines 1a and 1d to line 1e.
• Enter any of the employee’s deductions in line 1f. You should find this figure in Step 4b of the employee’s Form W-4.
• Divide the figure in 1f by the number of pay periods and enter the result in line 1g.
• Subtract the figure in 1g from the one in 1e to get the employee’s Adjusted Wage Amount. If this is 0 or less, enter 0.
• Use the table in the worksheet that corresponds to your payroll period to find the Tentative Withholding Amount.
• Claim tax credits from Step 3 of the employee’s Form W-4 using lines 3a to 3c of your worksheet. If this doesn’t apply, use the figure from line 2a for line 3c.
• Enter any additional amount to withhold from Step 4c of the employee’s Form W-4 into line 4a.
• Add the number in line 4a to that in line 3c to get the amount of federal income tax you need to withhold from the employee’s pay.

Step 3: Apply state and local taxes

It’s difficult to offer a calculation for this step as state and local taxes vary. Generally speaking, you apply the percentages for your state to your employee’s gross pay. Withhold this amount, which you earmark to pay to the relevant state or local authority.

For example, California has a graduated state tax of between 1% and 12.3%, depending on the employee’s income. It also has a state sales tax rate of 7.25% and a 2.5% maximum local sales tax rate. Though you may not need to account for the sales tax when calculating payroll taxes, you do need to consider the graduated state tax.

Let’s assume your employee earns $25,000. In this case, you apply the 1% state tax rate up to $18,650, creating a tax burden of $186.50. However, a graduated 2% rate applies to the earnings between $18,651 and $25,000. So, you apply a 2% rate to $6,350, creating a tax burden of $127. In total, the employee pays $313.50 in state taxes. 

Step 4: Calculate FUTA

Thankfully, it’s much easier to calculate the FUTA rate. Simply set aside 6% of the first $7,000 you pay to the employee. Note that the business pays this tax. It’s not withheld from the employee’s paycheck.

It’s also worth noting that some states receive FUTA credits, which may apply to your payments. These credits cover a maximum of 5.4% of the 6% you pay. But, not all states are eligible for the maximum credit.

Payroll Tax Withholding Example

The following is a quick example of tax withholding that applies to Social Security taxes.

Assume an employee earns $4,000 for the current pay period. Multiplying this figure by 6.2% tells you how much of that money to withhold:

4,000 x 0.062 = 248

As such, you withhold $248 from the employee’s pay. Furthermore, you must match this $248 with an employer contribution.

Key Takeaways

Payroll taxes can get extremely complicated. With so many tax categories to consider, it can all seem overwhelming.

FICA and federal income taxes apply to all employees, so you always need to account for them in your calculations. FUTA taxes aren’t withheld from pay, but they also apply to all employees.

State and local taxes complicate things because they don’t always apply. It’s best to consult a local financial professional to learn more. You may also benefit from outsourcing payroll duties if your business doesn’t have an accounting department.

FAQs on Payroll Taxes

How Much Payroll Tax Is Taken Out of My Paycheck?

In 2024, 6.2% is taken for Social Security, and 1.45% is taken for Medicare. You also pay federal and state income taxes relevant to your income.

Who Is Exempt From Payroll Taxes?

An employee may claim an exemption if they have the right to a refund on all income taxes withheld during the previous year. This usually happens if they have no tax liability for that year.

They may also claim an exemption for the current year if they expect to have no tax liability.

How Can I Reduce My Payroll Taxes?

Payroll taxes use set percentages, meaning you can’t alter how much an employee pays. However, employers may be able to deduct some of the taxes they contribute or claim credits for some taxes.

Is Payroll Tax the Same as Income Tax?

Income taxes are often a part of payroll taxes, but they’re not the same thing. Employers pay payroll taxes on behalf of employees. Income taxes are paid by the employee. An employer can withhold income taxes for employees, though this isn’t a given.

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