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Payroll Tax

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What are Payroll Taxes?

A payroll tax is imposed on employers by the federal or state government. Employers pay the tax on behalf of their employees. Eventually, employers collect the amount by deducting a percentage from employee salaries, wages, or commissions.

In the US, The Federal Insurance Contribution Act (FICA) uses the collected amount to fund retirement benefits, disability, old-age survivors, nursing home services, hospice care, hospital expenses, healthcare costs, and other citizen benefits. Payroll taxes are classified into three types—Social Security, Medicare, and Federal Unemployment taxes.

Key Takeaways

  • A payroll tax is a percentage imposition on the employee’s salary, wages, and commissions—collected by the state or federal government. The employer is responsible for submitting this tax, which is later deducted from the employee compensation.
  • The contribution collected under the Federal Unemployment Tax Act (FUTA) funds workers’ unemployment compensations.
  • These charges are often considered regressive—both rich and poor are equally burdened. It is imposed at a fixed rate up to a certain income cap.  

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Payroll Tax Explained

Payroll-Tax

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Payroll tax is a liability imposed by the Federal or State Government on employers. It is a percentage of wage expense spent on employees (who are on the firm’s PayrollPayrollPayroll refers to the overall compensation payable by any organization to its employees on a certain date for a specific period of services they have provided in the entity. This total net pay comprises salary, wages, bonus, commission, deduction, perquisites, and other benefits.read more). An amount is deducted from wage before disbursing.

It is a handsome source of revenue for the federal government. After all, the primary objective behind any tax is to eliminate fiscal deficitsFiscal DeficitsFiscal deficit refers to the situation where the total budget expenditure exceeds the total budget receipts, excluding the government borrowings in a given fiscal year. It determines the amount the government needs to borrow for meeting its excess expenditure.read more. Thus, it is a regressive form of taxation (in most countries).

The Federal Insurance Contribution Act (FICA) collects 15.3% of employee compensation. Of this 15.3%, 12.4% goes to The Social Security Program (6.2% paid by employer and employee each). The remaining 2.9%, however, goes to the Medicare Program (in which the employer and employee have an equal liability of 1.45% each). Also, the Federal Unemployment Tax Act (FUTA) imposes a 6% payroll charge—employer remits only 0.6%—5.4%, is received through credit.

Similarly, self-employed individuals also pay payroll charges to the government. For taxation purposes, ‘self-employed’ includes small business owners, lawyers, doctors, contractors, freelancers, etc. However, they have to bear both the employer’s share and the employee’s share of tax liability single-handedly.

Payroll Tax Types

There are following four types of payroll charges imposed by the state or federal government:

Components-of-Payroll-Tax

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#1 – Social Security Tax

The government charges a percentage of Social Security tax on the employer. The employee and the employer both contribute towards it. It is imposed at a fixed rate up to a certain income cap. In 2022, if income surpasses the Social Security wage base of $147,000, the amount above the income cap is not taxed.

The government uses collected taxes towards retirement benefits, disability, old-age survivors, and other citizen benefits. For example, in the US, FICA imposes a 12.4% payroll charge in 2022—the employer and the employee pay 6.2% each.

#2 – Medicare

The hospital insurance tax is a contribution made by the employer and the employee towards the medical insurance program. It is used for nursing home services, hospice care, hospital expenses, and other healthcare costs.

The government collects 2.9% of employee wages—the employer pays 1.45%, and the employee pays 1.45%. For self-employed individuals, 92.35% of earnings are subject to 2.9% Medicare charges. Unlike firms, self-employed individuals are not taxed on 100% of their earnings. FICA deducts 7.65% as an expense (wage tax expense on each dollar).

#3 – Federal Unemployment Tax

The Federal Unemployment Tax Act (FUTA) imposes a 6% payroll tax, and out of this, 0.6% is remitted by the employer for every $7000 spent on employee compensation. At the same time, the state collects the remaining 5.4% as credit.

The funds are used for unemployment compensationUnemployment CompensationUnemployment Compensation is a benefit provided by developed countries and a few developing countries to unemployed citizens who have lost their source of income due to retrenchment or layoffs.read more. The state unemployment tax agencies are responsible for collecting federal unemployment tax.

Payroll Tax Calculation Example

Let us look at some examples to understand the practical application of taxation.

Let us assume that Gemma works for Black PLC. As of March 31, 2022, her annual salary is $60,000. Now, calculate the payroll tax contribution deducted from Gemma’s salary (in accordance with FICA rates).

Solution:

Employee’s Contribution:

Towards Social Security: 6.2% of $60,000 = $3,720

Towards Medicare: 1.45% of $60,000 = $870

Total Employee Contribution = $3,720 + $870 = $4,590

Employer’s Contribution:

Towards Social Security: 6.2% of $60,000 = $3,720

Towards Medicare: 1.45% of $60,000 = $870

Total Employer Contribution = $3,720 + $870 = $4,590

Total Contribution to FICA = $4,590 + $4,590 = $9,180

On behalf of the employer and Gemma, a total payroll tax of $9,180 is paid to the government.

Employers can use the Payroll Tax Calculators to determine the exact amount.

Problems and Solutions

These charges referred to as a regressive tax Regressive TaxA regressive tax is the system of taxation where all citizens in the country are taxed at the same rate without considering their income levels. As a result, a more significant percentage of the income of the low-income group is charged as tax compared to the high-income group.read more—both rich and poor are equally burdened. But, there are alternatives that can reduce the burden on economically disadvantaged sections of society.  

For instance, removing the entire income capping would lead to a massive increase in additional government revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more. This way tax burden on individuals will increase according to their net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus.read more. Such a policy, if implemented, would lower marginal income tax ratesMarginal Income Tax RatesA marginal tax rate is a progressive tax structure in which an individual's tax liability grows in proportion to the amount of income he earns over a course of a financial year. It ensures that all citizens are judged equally based on their income.read more on corporate and personal incomePersonal IncomePersonal income refers to the total earnings of the individuals and households of a nation through multiple sources such as salary, wages, business profits, bonus, investment returns, dividends, rental receipts, employer contribution in provident or pension funds, etc.read more.

There is a need for simplified payroll charge forms and rules—so that entities can file taxes quickly.

Frequently Asked Questions (FAQs)

What is the payroll tax percentage?

According to Federal Insurance Contribution Act (FICA), a 15.3% tax is imposed on employee wages. For the Social Security Program, both the employee and the employer contribute 6.2% each. In addition, they contribute 1.45% each to the Medicare program.

Who pays the payroll tax?

The employer is liable to pay the tax to the government on behalf of the employees. This amount is later deducted from the employee compensation.

What is the difference between payroll and income taxes?

The payroll tax is the indirect tax imposed by the State or Federal Government for special programs like Medicare and Social Security. It is paid by the employers on behalf of the employees. The government collects a percentage of salary, wages, or commission.

In contrast, income tax is a direct tax imposed on individual earnings and firms’ earnings. Also, it is paid by the person who is liable.

This article has been a guide to what are Payroll Taxes & definition. We explain payroll tax for employers, rates, meaning, components & examples. You can learn more about accounting from the following articles –

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