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What is the Federal Unemployment Tax Act (FUTA)?

definition

The Federal Unemployment Tax Act is a federal law that requires employers to pay a tax to help fund payments to unemployed workers.

🤔 Understanding FUTA

Individuals who lose their jobs are often eligible for unemployment benefits through a state-run unemployment agency. The Federal Unemployment Tax Act (FUTA) gave the federal government the ability to impose an unemployment payroll tax on businesses to fund unemployment programs. Employers pay unemployment taxes based on a percentage of their employees’ wages, up to a certain amount. The federal government then distributes this money to state agencies, who are responsible for making benefits payments to unemployed individuals. In addition to the unemployment tax employers pay at the federal level, they may also pay a state unemployment tax. Unlike other federal taxes, such as the Social Security Tax, employees do not contribute to the FUTA tax.

example

Imagine William has been working for the past 10 years as a mechanic. During that time, William’s employer has been paying federal unemployment taxes on William’s wages. Due to budget cuts, William’s employer has to lay him off. Thanks to the unemployment taxes that William’s employer and others have paid under the Federal Unemployment Tax Act (FUTA), William can receive an unemployment benefit from his state temporarily (the exact amount of time varies by state).

Takeaway

FUTA taxes are like a shared emergency fund…

When you put money into your emergency fund, you’re setting aside money for a financial emergency, such as a job loss. The federal unemployment tax works kind of the same way, except employers all contribute to one big emergency fund that workers can benefit from if they lose their job.

Tell me more...

How does the Federal Unemployment Tax Act work?
Who is exempt from FUTA tax?
What is the difference between FUTA and SUTA?
How do you calculate FUTA tax?
What are FUTA taxes used for?

How does the Federal Unemployment Tax Act work?

President Franklin D Roosevelt signed the Social Security Act of 1935 into law. The bill did many things, one of which was to create an insurance program for unemployed individuals. Unemployment at the time was high as a result of the Great Depression — This piece of the bill was a response to that dilemma. The passage of the Federal Unemployment Tax Act (FUTA) in 1939 created the current framework where the unemployment fund is a joint venture between the federal government and state governments.

Under FUTA, any employer that paid at least $1,500 during any calendar quarter in the year must pay FUTA taxes to the federal government. Unlike other federal taxes such as FICA taxes (Social Security and Medicare taxes together), employees do not have to pay FUTA taxes on their wages.

The amount of FUTA taxes that an employer must pay is a percentage of the wages they pay each employee. The current FUTA tax rate is 6%, meaning employers must pay an amount equal to 6% of each employee’s wages to the federal government. FUTA has a wage base of $7,000 annually, meaning employers only pay that 6% tax on the first $7,000 of an employee’s pay. As a result, the maximum amount that an employer would have to pay for any particular employee is $420.

Employers usually have to pay FUTA taxes quarterly, but only if the amount they owe is more than $500. If they do not owe $500 in FUTA taxes after a single quarter in the year, they can roll that amount over to the next quarter until the end of the year or until they owe more than $500 in FUTA taxes.

Suppose a small business owes $200 in FUTA taxes for the first quarter of the year. Since they don’t owe more than $500, they can roll it over to the next period. They owe another $200 for the second quarter, bringing the total amount they owe to $400. Since they still don’t owe $500, they can roll the amount over again. The employer owes another $200 for the third quarter, which brings the total amount they owe to $600. Because the amount they owe now exceeds $500, they’ll have to pay FUTA taxes at the end of the third quarter.

Who is exempt from FUTA tax?

Not all wages are subject to the FUTA tax. For example, if a business owner employs their spouse or their child under the age of 21, they don’t have to pay FUTA taxes on those employees’ wages. This rule does not apply if you are an owner of a corporation or partnership — In that case, the individual works for the corporation or partnership, not for you.

Other types of payments are also exempt. The Internal Revenue Service (IRS) considers the following forms of compensation to be exempt from FUTA taxes:

-Fringe benefits: These benefits can include the cost of meals and lodging, contributions to employee health insurance, and contributions to other benefits such as health savings accounts (HSA).

  • Group term life insurance: If the employer provides payments for group term life insurance to employees, the employer does not have to pay FUTA taxes on that amount.

  • Retirement/pension: Employers do not have to pay FUTA taxes on the money they contribute to employees’ retirement accounts such as 401(k) plans, SIMPLE individual retirement accounts, and pension plans.

  • Dependent care: If the employer pays for the care of a dependent of an employee, up to $5,000 per year would be exempt from FUTA taxes.

  • Other payments: Other various payments could be exempt from FUTA taxes, including payments made under workers’ compensation, non-cash payments for some farm employees, payments for some fishing activities, and payments for some domestic services.

What is the difference between FUTA and SUTA?

In addition to the Federal Unemployment Tax Act (FUTA), there is also a State Unemployment Tax Act (SUTA) with works in conjunction with FUTA to create the unemployment insurance fund in each state.

While all employers have to pay the FUTA tax, employers in some states also pay a SUTA tax. There is a tax credit available to those employers that pay a SUTA tax — If an employer pays both a FUTA tax and a SUTA tax, they can receive a credit of up to 5.4% of FUTA taxable wages. This credit will reduce the amount of FUTA taxes the employer owes.

The rates of SUTA taxes vary widely from state to state. In some states, such as Arizona and California, employers pay SUTA taxes on only the first $7,000 of an employee’s wages each year. Other states have a much higher cap. For example, employers in Alaska pay SUTA taxes on the first $39,800 of an employee’s wages, and those in Hawaii pay on the first $40,400.

And while the FUTA tax and most SUTA taxes apply only to employers, three states (Alaska, New Jersey, and Pennsylvania) require employees to pay SUTA taxes as well. This tax is a withholding tax, meaning employers withhold the amount from their employees’ wages and send the tax money to the state government.

How do you calculate FUTA tax?

To calculate taxes under the Federal Unemployment Tax Act (FUTA), an employer should first add up the total amount of compensation they’ve paid to a particular employee over the calendar year. Start with all employee gross pay and benefits.

Then, subtract the forms of compensation that are exempt from FUTA taxes. These include health insurance and retirement account contributions. If the sum is more than $7,000 for the year for any single employee, reduce the amount to $7,000.

Finally, for each employee, multiply their wages (up to $7,000) by 6%. If an employer also pays taxes under the State Unemployment Tax Act (SUTA), they can multiply by 0.6%, since they’ll be eligible for a 5.4% credit.

What are FUTA taxes used for?

The purpose of the taxes the government collects under the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA) is to pay for state unemployment insurance programs.

When an employee loses their job, they might be eligible for unemployment compensation. The purpose of these payments is to help provide income for unemployed individuals while they look for a new job. Unemployment compensation is available to anyone who lost their job through no fault of their own. So if they lost their job due to layoffs, they could receive coverage — If the worker lost their job due to poor job performance, they might not be eligible.

To receive unemployment benefits, an individual must almost have earned a certain amount of money before unemployment and must be able to work and actively seeking work. Many states require unemployment beneficiaries to submit a weekly report with the jobs they applied for that week.

Each state has a maximum number of weeks that an individual can receive unemployment benefits. In most states, the duration is 26 weeks. Some states offer more. For example, Massachusetts provides 30 weeks, while Montana provides 28. Other states provide fewer weeks of compensation — In Missouri, you can only receive unemployment benefits for 13 weeks.

Other states, rather than having a set number of weeks that they always use, adjust their time limits periodically based on the state’s unemployment rate. When the unemployment rate goes down, the number of weeks they’ll provide benefits also goes down.

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