What is Payroll Tax? Definition, Calculation, Who Pays It
There are several taxes an employee pays on their payroll, they include social security tax, medicare tax, federal income tax, and state income tax. All the various taxes listed above are payroll tax.
Your employer is mandated by law to deduct your payroll tax from your paycheck and pay it to the appropriate tax bodies. According to SmartAsset, both employees and employers pay 15.3% of their earnings as federal income taxes. The Social Security Tax rate is 6.2% and the Medicare Tax rate is 1.45%. Federal income tax accounts for 7.65%.
In this article, you will learn everything you need to know about payroll taxes such as how to calculate payroll taxes, who really pays payroll taxes, and the best payroll software for employers.
Let’s get started.
What is Payroll Tax? A Short Definition
Payroll tax is the percentage of money employees earn that employers deduct to pay the government. The employers withhold a part of the employees’ salary to pay part of the employee payroll tax through payroll deduction.
According to Investopedia, “Payroll tax is a percentage withheld from an employee's pay by an employer who pays it to the government on the employee's behalf.”
If you are wondering why your take-home wages or salary is different from what you are supposed to earn, the deduction of the payroll tax from your earnings is the reason.
An employer is legally required to perform payroll tax responsibilities by withholding certain percentages of an employee’s gross pay. The amount withheld is for payroll tax. What the employee pays the employee after removing the payroll tax is net pay.
Payroll tax is not a single tax, rather it is a term that covers all the taxes employees pay on their wages or salaries. These wages or salaries do not just cover the traditional meaning of the words. It also includes overtime pay, gifts, profit sharing, bonuses, and all compensation that employees receive on payday.
Types of Payroll Taxes
There are several types of payroll taxes. They can be divided into federal, state, and local payroll taxes.
1. Federal or Regular Income Tax Withholdings
This tax type falls under compulsory deductions. Employers must withhold the federal or regular income tax from employees’ earnings or paychecks and send it to the IRS.
Employees have the option of adjusting their federal or regular income tax. To do this, they have to file a Form W-4 with their employers.
Employees decide how much they get deducted from their earnings for federal income tax. If they choose a large amount, any amount overpaid they receive as a refund on their year-end taxes. If they choose a small amount, they may have to pay the remaining balance owed at the end of the year.
Federal or regular income tax is a progressive tax. The more you earn, the more federal income tax you pay, and the less you earn, the less you pay for federal income tax. For example, the lowest tax percentage was 10 percent, which increases to 15 and above depending on the tax bracket you fall into.
Calculating the amount that an employee owes the federal government as federal or regular income tax is easy with the IRS Withholding Calculator. Payroll tax is calculated as the percentage of their earnings based on their taxable income, number of claimed allowances, and marital status.
2. Federal Insurance Contribution Act (FICA) Taxes
This tax consists of two federal tax programs: Social Security and Medicare. The Federal Insurance Contribution Act (FICA) taxes are shared by employer and employee. The employee pays 6.2% of their earnings for Social Security and 1.5% for Medicare. It is the same percentages that the employer contributes as their FICA taxes.
FICA taxes are a regressive tax, different from the Federal Income Tax which is a progressive tax. For example, any income or earnings above the Social Security wage base (which was $137,700 in 2020) do not attract Social Security tax.
The rate for FICA taxes (Social Security – 6.2% and Medicare – 1.45%) does not change but the earnings on which those percentages are applied change frequently. For example, in 2006, Social Security tax was due on the first $94,200 and nothing beyond it, while Medicare did not have such limits.
Self-employment means more taxes. Self-employed individuals pay more FICA taxes than employees. Since they do not work under an employer and are their own boss, they pay both the employer and employee portions of the FICA tax. Their total FICA tax contribution is 15.3%.
3. Federal Unemployment Taxes and State Unemployment Taxes
The Federal Unemployment Tax is derived from the name of the original act, the Federal Unemployment Tax Act (FUTA). It is a tax not paid by the employees but the employers.
Employers are required by both the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA) to pay both the federal and state unemployment insurance taxes for each employee. The FUTA tax rate is 6% on the first $7,000 an employee earns yearly.
However, the employer ends up paying 0.6 percent of $7,000 which is $42 on every employee yearly. The reason for this is because the tax structure allows employers to take up 5.4% of the FUTA tax as a credit against State Unemployment Tax.
Note that some states can set their own unemployment tax rates higher than the custom 5.4% and even levy the State Unemployment Tax on more than the $7,000 benchmark. State Unemployment Tax rate differs from one state to another.
In 2003, the national average for State Unemployment tax was 2.1 percent, which was charged on the first $7,000 – $9,000 of an employees’ earning. A year later, the national average rose to 5.4% -11% on the same yearly income range of employees.
Companies and businesses that have a record of laying off a high percentage of their employees pay higher than companies and businesses that lay off fewer numbers. The reason is simple, companies that lay off a high percentage of their employees have to pay more because of the higher amount of Unemployment Insurance (UI) benefits their ex-employees receive.
4. State Income Taxes
The State Income Taxes is similar to the Federal Income Taxes, the only difference is that it is paid at the state level and determined by the state. The amount you pay as state taxes varies from one state to another.
In situations where an employee works in one state and lives in another, state taxes are paid to the state in which the employee lives.
State Income Taxes are calculated based on many factors such as W-4, taxable income, marital status, and the number of allowances. Employers do not contribute to state tax owed, employees have to pay the full amount.
5. Workers' Compensation Benefit Funds
Workers’ compensation benefit funds are state-run funds that help support employees who incur injuries or illness as a result of performing their work duties.
Employees do not contribute to this benefit fund, rather employers must contribute to it. The worker's compensation benefit funds are governed by state workers' compensation laws.
6. Self-Employment Taxes
Self-employment taxes are similar to FICA taxes and consist of Social Security and Medicare taxes for self-employed individuals. Self-employed individuals pay double the Social Security and Medicare taxes that employed individuals.
Unlike FICA taxes where employees contribute to employees’ Social Security and Medicare taxes, self-employed individuals have to bear the full burden. The self-employment tax rate consists of 12.4% for Social Security and 2.9% for Medicare, totaling 15.3%.
The Social Security rate of 12.4% is only calculated below the annual maximum income limit for the calendar year. There is an Additional Medicare for self-employed individuals who earn more than $200,000 in a calendar year.
Unlike other payroll taxes, self-employment taxes do not get withheld from the individual pay. You have to pay it as part of your personal tax return.
How to Calculate Payroll Taxes (Including Best Payroll Tax Calculators)?
Calculating payroll taxes can be tricky, but if you are an employer, you need to get it right to avoid complications. The percentage of Federal Income Tax is not the same for everyone. Every new employee has to fill out the IRS Form W-4 (Employee’s Withholding Allowance Certificate) which requires information about their name, address, and social security number.
Other information provided on the W-4 Form such as marital status, the total number of children and dependent, and gross salary determine the Federal Income Taxes withheld from an employee’s check.
Not all payroll taxes have standard amounts or rates, other payroll taxes such as Social Security Tax, Medicare Tax, and Unemployment Taxes have standard amounts or rates.
Social Security Tax Rate Calculation
The Social Security Tax rate is 12.4%, which is split by the employer and the employee equally. The employer pays 6.2% while the employee pays 6.2%. The maximum income amount based on the 2021 tax year that can be subjected to Social security Tax is $142,800. Any earnings above $142,800 are not subject to this tax.
For example, if an employee’s gross wage is $2,083.33. If the employee wants to find out the Social Security Tax to deduct, he simply multiplies the gross wage ($2,083.33) by 6.2%. The Social Security Tax to withhold from the employee’s paycheck is $129.17.
Medicare Tax Rate Calculation
The Medicare Tax rate is 2.9%, which is again split by the employer and the employee equally. Both pay 1.45% each. Although there is no base wage limit for Medicare Tax, if you earn above $200,000 a year, you will have to pay an extra 0.9% as Additional Medicare Tax. This Additional Medicare Tax is only paid by the employee.
For example, if an employee’s gross wage is $2,083.33. If the employee wants to find out the Medicare Tax to deduct, he or she simply multiplies the gross wage ($2,083.33) by 1.45%. The Medicare tax to withhold from the employee’s paycheck is $30.21.
Federal Unemployment Tax Rate Calculation
The Federal Unemployment Tax rate is 6.0%. It is only applicable on the first $7,000 in wages an employee earns in a year. Unlike the Social Security Tax and Medicare Tax, only the employee pays it.
Here is how to calculate your Federal Unemployment Tax Rate. For example, if your gross wage is $2,083.33, and your Federal Unemployment Tax rate is 6%, you multiply both your gross wage and your Federal Unemployment Tax rate.
$2,083.33 x 0.06 (6/100) = $124.99. Your Federal Unemployment Tax for your paycheck is $124.99.
If your company is subject to state unemployment, you pay a Federal Unemployment Tax rate of 0.6%, thanks to the federal tax rate credit of up to 5.4% you receive.
$2,083 x 0.06 (6/100) = $12.50. Once your earnings exceed $7,000, you are no longer subject to the Federal Unemployment Tax.
Best Payroll Tax Calculators
Simple and Quick Payroll Tax Calculator
QuickBooks is one of the best accounting software for employers and businesses and offers a free payroll calculator that is simple to use. The paycheck calculator makes it easy for employees to calculate the paychecks of their employees (both hourly and salary).
The calculator is split into four parts: Pay Information, Additional Pay, Federal Tax Information, and State Tax Information. It helps you track overtime, bonus, and commissions, and calculates federal, state, and local tax information.
Simple Payroll Calculator
Payroll Calculator is a neat and simple payroll calculator that helps you calculate the payroll taxes of individuals. When using the software, ensure to pick the appropriate state to avoid getting misleading information as state income taxes vary from one state to another.
The software is easy to use even for non-accounting experts.
Who Really Pays Payroll Taxes?
You may think that employees and employers share the brunt of paying payroll taxes, and at least that is how it should be. In reality (a secret kept away from employees), employees pay almost all the payroll tax they owe.
Why is this so? Why is the payroll tax burden not split equally between employees and employees? To find the answer you have to look at the market. Tax incidence is not influenced by the law put out but rather by the swing of the market.
Employers and employees share equally the burden of the Social Security Tax and Medicare Tax. However, in reality, the bulk of the burden is on the shoulders of the workers. Employers have a way of paying less and subjecting the tax burden on their workers.
According to the Tax Foundation, the majority send their tax portion to the IRS or appropriate tax bodies and then decrease employees’ wages. As a result instead of employees and employers paying the 7.65% payroll tax for Social Security and Medicare, they pay their own portion and then decrease employees’ wages by nearly the 7.65 percent paid. The employee is the one who really pays payroll taxes.
What Does Payroll Tax Deferral Mean?
Payroll Tax Deferral is the act of suspending your payroll taxes. Ex-President Donald Trump introduced it towards the end of 2020 as a COVID-19 relief program to provide more cash for low-income employees.
The idea of payroll tax deferral is simple, employers suspend the deduction of social security taxes for employees’ wages. This move gives employees more money to spend or earnings to keep. However, the social security tax deducted is not suspended permanently. At a later date, you still have to pay it.
Many employees and critics do not support the payroll tax deferral, as it provides only temporary relief for employees, and then gives them a big tax burden in the future.
According to Investopedia, President Joe Biden signed the American Rescue Plan Act into law on the 11th of March 2021. The 1.9 trillion dollar bill extended much federal support for small businesses such as the payroll tax deferral.
The payroll tax deferral is only applicable for the employer portion of social security taxes. Self-employed individuals can only defer 50% of their social security self-employment tax rate of 12.4%. Payroll tax deferral does not apply to Medicare taxes.
Best Payroll Software for Employers
Best Payroll Software for Employers with the Simplest Setup
OnPay is a payroll software that covers the basic payroll functions such as garnishing wages and withholding state unemployment insurance. It provides employees with multiple payment options such as paper checks.
The payroll software is a good fit for many industries such as restaurants, agriculture, nonprofits, and others. OnPay tailors its services to meet the payroll needs of specific industries.
If you need help setting up your payroll. OnPay has experts on hand to support you. The software offers multi-state payroll, supports time-tracking, and integrates seamlessly with accounting software. OnPay makes employee onboarding easy and has an accurate tax filing guarantee.
2. Wave Payroll
Most Affordable Payroll Software for Small Businesses
Wave Payroll is an affordable payroll software that integrates seamlessly with Wave accounting software. The software gives you 100% tax accuracy, pay stubs, new-employee reporting, and end-of-the-year tax forms features.
If you run a small business and need automated payroll software that affords you more time to handle your business, Wave Payroll is ideal for you. You can use the software to print paychecks in-house. Its full-service payroll is however available in 14 states. These states include Arizona, California, Florida, Georgia, Illinois, Indiana, Minnesota, New York, North Carolina, Tennessee, Texas, Virginia, Washington, and Wisconsin.
The payroll software makes the whole payroll accounting look easy for small businesses. Employees can also access their payroll thanks to its employee access feature.
Comprehensive and Intuitive Payroll Software
Gusto is an intuitive and comprehensive payroll software that offers a rich abundance of features. The software helps you automate your local, state, and federal payroll tax filing. It also offers PTO (paid time off) tracking and generates paystub and W-2 access for employees.
The payroll software calculates wage garnishment deduction and workers compensation. You can integrate your small business accounting software with the Gusto Payroll software. If you use time-tracking software, you can integrate it with Gusto.
Although Gusto files your taxes for you, you have to manually press the button for it to do so. Gusto does not allow autopilot mode for tax filing.
Payroll Software with Best Customer Service
SurePayroll is a simple payroll solution for small businesses. The software offers a tax-calculation guarantee and a 100% tax-filing guarantee when you subscribe to its full-service option. The tax-filing guarantee means that if there are any errors in your tax calculations, the software takes full responsibility for it.
The payroll software boasts of having the best customer service which is available for 6 days a week and has extended working hours. SurePayroll offers payroll flexibility and supports multiple vertical payroll software.
If you are a busy small business owner, and not knowledgeable about payroll tax calculations, SurePayroll is the helping hand you need for support. The cloud-based payroll software integrates with accounting software such as Xero, QuickBooks, and other QuickBooks alternatives.
Best Payroll Software with Powerful and Rich Payroll Features
QuickBooks Payroll is a product of Intuit. The company is reputable in creating world-class software such as accounting software, inventory management software, time-tracking software, and payroll software.
If you have an existing QuickBooks account, you can easily integrate it with QuickBooks Payroll. The powerful payroll software offers lots of rich payroll features such as automatic payroll runs, direct deposits, multi-state payroll services, payroll reporting, and wage garnishment.
The cloud-based payroll software is easy to use and does not require any learning curve. Ir has a mobile app which makes it even easier to use and access the software.
Best Payroll Software for Contract Work
Square Payroll is a full-service payroll and automated tax filing software. If you need help to pay contract workers such as freelancers and contractors, Square Payroll Payroll is a good fit.
The software makes it easy for contract workers or employees to clock in and out, which greatly assists in the calculation of their earnings.
Square Payroll is suitable for small to medium-sized businesses with up to 100 employees. It handles your federal and state payroll taxes. You can set a sick leave or paid time off policy for each employee, the payroll software handles the payroll calculations.
Affordable Payroll Software for Small Businesses
Patriot Software is a payroll management software designed for small businesses. It is an affordable payroll software that offers the necessary tools to manage and maintain payroll records, direct deposits, print checks, file states, and federal taxes, and provide tax reports.
The payroll software has an exceptional setup wizard and good employee portals. New users can use its excellent guides to figure out how best to use the software.
Apart from performing the basic payroll taxes, the software also processes payroll runs, determines deductions, and submits payroll taxes. The software can pay both contractors and employees within the same payroll runs.
Most User-Friendly Payroll Software
Wagepoint is a small business payroll software with a friendly interface and a supportive customer service team. The software makes it easy to pay your employees when due and helps you stay on top of your tax obligations.
All the features you need to run a smooth payroll operation for your business are available on the Wagepoint software. The software supports direct deposit, tax filings (federal and state), payroll reporting, online pay stubs, multi-state and multi-country (Canada and the United States) taxes, and other features.