While our Fast Wage and Tax Facts tool is handy in a pinch, knowing the ins and outs of payroll taxes can help support longer-term compliance efforts
Over the years, the term “payroll tax” has become synonymous with all things taxes on a pay stub. In reality, however, payroll taxes are different from income taxes and serve a distinct purpose for public welfare. With careful attention to compliance, employers can help fulfill this societal benefit and avoid significant penalties.
What is payroll tax?
A payroll tax is a tax levied by federal, state or local governments to help fund public programs. It is typically paid for via direct contributions from employers, as well as deductions from employee wages, hence the name payroll tax.
What is an example of a payroll tax?
Payroll tax examples include Medicare, which provides health coverage for adults over age 65, and Social Security, which provides retirement income for adults age 62 and older, as well as certain disabled individuals and certain survivors of taxpayers.
What is the difference between payroll tax and income tax?
Payroll taxes have flat rates and are sent directly to the program for which they are intended, e.g., Medicare, Social Security, etc. Income taxes, on the other hand, have progressive rates that vary with total income and go to the U.S. Department of the Treasury, where they may be used to fund various government initiatives. In addition, some payroll taxes have a wage base limit, after which the tax is no longer deducted from the employee’s wages for the remainder of the year. Income taxes have no such cap.
What are the basic types of payroll tax?
Several types of payroll taxes exist at the national and state levels. They are as follows:
- Federal payroll tax
Better known as Federal Insurance Contribution Act (FICA), the federal payroll tax has two parts – one for Medicare and the other for Social Security.
- Social Security payroll tax
Employers and employees share in the Social Security tax, with each paying half of the total liability until the employee reaches the wage base limit of $160,200.
- Medicare payroll tax
Medicare tax is also split evenly between employers and employees, but unlike Social Security, it doesn’t have an earnings limit. However, certain employees making more than $200,000 per year may have to pay an additional Medicare tax, which employers aren’t required to match.
- Unemployment taxes
Employers alone pay federal unemployment tax (FUTA) on the first $7,000 that every employee earns. The same is true for state unemployment programs, except the wage base limits vary, and in a few states, employees also contribute to the tax. Employers who pay their state unemployment on time and aren’t in a credit reduction state may be eligible for a lower federal unemployment tax rate.
- State and local payroll tax
Some states and municipalities may have additional payroll taxes for short term disability, paid family medical leave or other programs. Employers should check with their local authorities for specific requirements.
Understanding payroll taxes
To employees, payroll taxes may simply be line items on a pay stub, but employers need to have a more in-depth understanding of related topics, such as:
- Payroll tax deductions
With some exceptions at the state and local levels, the only payroll taxes that employers deduct from employee wages are Medicare tax and Social Security tax.
- Payroll tax rates
Payroll taxes are charged via flat rates. Here are the latest federal rates per employee:
- Social Security – 6.2%
- Medicare – 1.45%
- Additional Medicare – 0.9%
- Unemployment – 6% (0.6% with full credit reduction)
State unemployment tax rates typically vary based on an employer’s previous claims history. As such, a business with many previous employees who have filed unemployment claims will tend to have a higher rate than a business that has none. Other state and local payroll tax rates differ by location.
- Depositing and filing payroll tax
FICA taxes (Medicare and Social Security) are paid either monthly or semi-weekly, depending on the business’s tax liability during a lookback period, and FUTA taxes are generally paid quarterly. In both cases, employers may use the Electronic Federal Tax Payment System to make their deposits.
Businesses must also report how much federal payroll tax they withheld and paid throughout the year. For FICA taxes, this is typically done quarterly, but in some instances where the total tax liability is small, it may be done annually. FUTA taxes are reported annually.
State payroll tax deposit and filing procedures vary by state.
- Payroll tax deferral
The Coronavirus, Aid, Relief and Economic Security Act (CARES Act) contained a provision that allowed businesses to defer payments of the employer portion of Social Security taxes otherwise payable March 27, 2020 through December 31, 2020. Employers who took advantage of these relief measures should consult a licensed tax professional if they need advice on how to manage the repayments.
- Self-employment payroll taxes
Independent contractors and solopreneurs may not have an employer to withhold payroll taxes from their wages, but that doesn’t mean they’re completely off the hook. Instead, they pay self-employment tax, which effectively combines the employee and employer portions of FICA tax. The current rate is 15.3%, broken down as follows: 2.9% is paid to Medicare and 12.4% is paid to Social Security. As mentioned previously, Social Security has a wage base limit of $160,200.
How do employers calculate payroll tax?
Payroll taxes are calculated by multiplying an employee’s gross taxable wages against the applicable payroll tax rate. For example, if the gross taxable income for a particular pay period was $1,250, then the Medicare deduction would be 1,250 x 1.45% = $18.13 and the Social Security deduction would be 1,250 x 6.2% = $77.50. Payroll tax calculations like these are usually simpler than those for income tax because the rates are flat and withholding certificates aren’t necessary.
Payroll tax compliance
Since they are deducted from employee wages and held in trust by the employer until remitted to the relevant agency, FICA taxes are considered a type of trust fund tax. This means that a compliance violation can expose businesses to the trust fund recovery penalty (TFRP). Infractions occur when the individual(s) responsible for collecting, accounting and paying taxes willfully fails to do so. The IRS defines willfulness as having awareness of the outstanding taxes and either intentionally disregarding the law or behaving indifferently to its requirements.
How can employers avoid payroll tax penalties?
Employers who proactively manage their payroll taxes are more likely to avoid penalties than those who don’t. Here are some preventive tips:
- Classify employees correctly
Misclassifying employees as independent contractors to avoid paying FICA and FUTA taxes is illegal.
- Withhold and pay taxes on time
Using payroll funds to pay another creditor instead of the IRS is an example of willful disregard and may result in a TFRP.
- File tax reports using the proper forms
Employers must file amended returns if they make a mistake or use the wrong form.
- Stay up-to-date with tax law changes
Payroll tax rates and wage base limits are subject to change by federal, state and local governments.
- Partner with a qualified payroll service provider
Payroll software automates FICA calculations, deductions and payments to help ensure accuracy.
Frequently asked questions about payroll tax
What is a payroll tax cut?
The payroll tax cut or tax holiday that occurred as a provision of the CARES Act in 2020 was actually a deferral. Employers who did not remit the employer portion of Social Security tax during the deferral period were required to do so by a later date.
Does everyone pay payroll tax?
In general, most employers and employees pay Social Security and Medicare taxes. Exemptions apply, however, for certain classes of nonimmigrant and nonresident aliens. Examples include nonimmigrant students, scholars, teachers, researchers and trainees (including medical interns), physicians, au pairs, summer camp workers, and other nonimmigrants temporarily present in the United States in F-1, J-1, M-1, Q-1 or Q-2 status.1
What is the federal payroll tax rate?
The current FICA tax rate is 15.3%. Paid evenly between employers and employees, this amounts to 7.65% each, per payroll cycle.
Is payroll tax flat or progressive?
Unlike income taxes, payroll tax rates are flat, which means that all employees pay the same percentage regardless of their total income. Some payroll taxes, however, have wage base limits.
How do I pay payroll tax?
Federal payroll taxes are paid online using the Electronic Federal Tax Payment System. Payment methods for state and local payroll taxes vary by location.
This guide is intended to be used as a starting point in analyzing an employer’s payroll obligations and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.