What is a Payroll Tax?

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Definition:

A payroll tax is a tax that employers deduct from their employees’ paychecks and send directly to the government.

🤔 Understanding payroll taxes

When people get their paychecks, they don’t typically get every dollar they earned deposited directly to their bank accounts. Instead, they get a reduced amount based on the deductions that their employer removed from the check. Some deductions, like employee benefit programs, are optional — others are not. Payroll taxes are a deduction that employers make from almost every employee’s paycheck. These deductions pay for different types of taxes, including federal and state income tax and Social Security. The size of the deductions varies with the tax rates and the size of the employee’s paycheck. Employers also pay payroll taxes based on what they pay their employees, even if the employees do not see those deductions.

Example

A person who makes $20 per hour and works two 40-hours weeks, is earning $1,600 (20 x 40 x 2). When they get their paycheck, they see the gross amount they received, $1,600, followed by several deductions. For example, they see a deduction for Medicare and Social Security taxes totaling $122.40, which covers the 7.65% rate for these payroll taxes.

Takeaway

A payroll tax is like giving part of your meal to someone else before you take your first bite...

At lunchtime, you make yourself a sandwich in your kitchen and bring it to your living room to eat. When you get there, your roommate is sitting on the couch. He asks for some of the sandwich, and you slice off part of it and give him the slice before you start eating. Similarly, payroll taxes take a slice of your earnings before your employer deposits them to your checking account.

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What is a payroll tax?

Payroll taxes are taxes that employers automatically deduct from their employees’ paychecks and send to the government. The size of the charge relates to the amount that each employee earns. Employers also have to pay some payroll taxes based on their employees’ earnings, even if the employees do not see those taxes removed from their paycheck.

Some common examples of payroll taxes are Social Security tax, Medicare tax, federal and state unemployment taxes, and local taxes. Employers also deduct federal, state, and local income taxes from their employees’ paychecks, but some people make a distinction between income taxes and payroll taxes because they function slightly differently.

How do payroll taxes work?

Both employees and employers pay payroll taxes based on the gross pay that each employee receives. For example, a 5% payroll tax would reduce an employee’s net income from a paycheck from $1,000 to $950.

Employees can see the payroll taxes they pay on their pay stub. Their pay stub should include their hours worked and hourly rate, resulting in a gross total for their paycheck. Then, it should outline each of the taxes their employer deducted. These deductions will include payroll taxes like Medicare and Social Security. They’ll also include federal and state income taxes.

After deducting taxes, the employer deducts other, non-tax, items from the employee’s paycheck. This includes deductions to pay for medical insurance, to fund a 401(k), or to pay for other employee benefits the worker elected to take advantage of.

Once the employer removes all the deductions from the employee’s paycheck, the worker receives the net amount in their paycheck.

Typically, the government bases payroll taxes on the gross amount that the worker earns. You pay income tax based on your annual income, adjusted for different factors, such as contributions to retirement accounts, but most payroll taxes don’t adjust for deductions.

Employers also pay payroll taxes, but they do not appear on the employees’ paychecks. The amount the employer pays is still based on the size of their workers’ paychecks.

Who pays payroll taxes?

Both employees and employers pay payroll taxes. Which taxes each pays depends on the tax code.

In the United States, employees pay payroll taxes like Social Security tax, Medicare tax, and federal and local income taxes. Employers also pay Social Security tax and Medicare tax, plus they pay taxes that employees don’t, like unemployment taxes.

Self-employed people have to handle both employer and employee payroll taxes. They pay both because self-employed people are both their employer and employee in their one-person business. You’ll sometimes hear this called the self-employment tax because it means that independent workers have to pay more in payroll tax than regular workers.

How much does the employer pay in payroll taxes?

The amount that employers pay in payroll taxes varies with where the employer operates.

In the United States, there are two significant federal payroll taxes: Medicare and Social Security. Both employees and employers pay the same rate for these taxes. The rate is 6.2% for Social Security and 1.45% for Medicare. That means that employers pay a combined rate of 7.65% for these two payroll taxes. These are also often called FICA (Federal Insurance Contributions Act) taxes.

For example, Company A pays one of its workers $50,000 each year. Over the year, Company A will pay $3,825 in payroll taxes to cover the cost of Social Security and Medicare.

There are some additional rules for these taxes. For example, workers who earn more than $200,000 in a year pay 0.9% in additional Medicare taxes. Employers also have to pay an elevated rate on any money they pay to an employee over $200,000. On the other hand, only income up to $137,700 is subject to Social Security taxes, meaning neither the employer nor the employee pays the 6.2% Social Security tax on money made over that amount.

Beyond Social Security and Medicare taxes, some employers must pay unemployment taxes. Any employer who has at least one employee for one day of a week during each of 20 weeks in a year, and who paid wages totaling $1,500 or more during any quarter, must pay federal unemployment taxes.

The federal unemployment tax rate is 6% on up to $7,000 per year, but employers can receive a credit for up to 5.4% of the 6% tax if they pay their state unemployment taxes on time. State unemployment tax rates and rules vary from state to state.

What is the difference between payroll taxes and income taxes?

Employers withhold payroll taxes and income taxes from their employees’ paychecks, which is why there are often both lumped together and referred to as withholding taxes. But they work somewhat differently, which leads some tax experts to make a distinction between the two.

The significant difference between the two types of taxes is what the taxes are used for and how the government calculates the tax the employee must pay. Payroll taxes go to fund the Social Security and Medicare programs, while income taxes can be used by the government for any expenses.

The government calculates payroll taxes using the gross amount that businesses pay each worker. Income taxes are based on an adjusted income that each taxpayer derives based on their total income and a variety of deductions and other adjustments.

An IRS report in 2015 found that taxpayers who earned less than $40,000 a year, on average, paid no income tax. Still, those workers had to pay payroll taxes based on their gross income. Someone who earned $40,000 a year might pay no income tax but would likely pay $3,060 in payroll taxes to cover Social Security and Medicare payroll taxes. Their employers would pay even more to cover the additional expense of unemployment taxes.

How do you calculate payroll taxes?

Employees and employers pay payroll taxes based on the gross pay that workers receive. That makes calculating payroll taxes relatively simple. Figure out the tax rate for each payroll tax each must pay, then multiply it by the employee’s gross pay.

For example, if Jane earns $1,000 per paycheck, she must pay 6.2% in Social Security taxes and 1.45% in Medicare taxes. That means that she has to pay:

($1,000 6.2%) + ($1,000 1.45%) = $76.50

Because employers pay an equal amount in Social Security and Medicare taxes, the company that employs Jane will pay the same amount. The company also has to calculate the unemployment tax it owes based on Jane’s $1,000 gross pay.

What is the payroll tax rate for 2020?

In 2020, the two significant payroll tax rates are the Medicare and Social Security taxes. The Medicare tax rate is 1.45%, and the Social Security tax rate is 6.2%, making for a total payroll tax rate of 7.65%. Employers pay the same taxes, even though employees don’t see those payments on their paystubs, so you could also say the overall rate is 15.3% (though that ignores the varying cost of unemployment insurance).

Income taxes, which employers also deduct from workers’ paychecks, vary with the employee’s income and marital status. For 2020, the income tax rates are:

Tax rateSingleMarried, filing jointlyMarried, filing separatelyHead of household
10%$0 to $9,875$0 to $19,750$0 to $9,875$0 to $14,100
12%$9,876 to $40,125$19,751 to $80,250$9,876 to $40,125$14,101 to $53,700
22%$40,126 to $85,525$80,251 to $171,050$40,126 to $85,525$53,701 to $85,500
24%$85,526 to $163,300$171,051 to $326,600$85,526 to $163,300$85,501 to $163,300
32%$163,301 to $207,350$326,601 to $414,700$163,301 to $207,350$163,301 to $207,350
35%$207,351 to $518,400$414,701 to $622,050$207,351 to $311,025$207,351 to $518,400
37%$518,401 or more$622,051 or more$311,026 or more$518,401 or more
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