If only paying your employees was as easy as sending them their salary. But as with anything involving the Internal Revenue Service (IRS), it’s not so simple. First, you have to pay taxes on the employees' wages. And second, during each pay period, you have to withhold a certain portion of each employee’s salary for tax purposes.
Mandatory withholdings include payroll tax and income tax. These two types of taxes may sound like you can use them interchangeably, but they’re not the same.
Keep reading to learn the difference between payroll tax vs. income tax and how to calculate each for your employees.
What Is the Actual Difference Between Payroll and Income Taxes?
Payroll taxes fund specific government programs that individuals can receive benefits from when needed, such as unemployment or Social Security. On the other hand, income taxes are used by the government to pay for its regular operations and projects.
Another difference is who pays the taxes. Payroll taxes are either split between the employer and the employee or paid for fully by employers. In contrast, only employees pay income taxes.
However, employers still play a role in income taxes because they are usually responsible for deducting income taxes from employees’ paychecks and sending that money to the government on their behalf. This can all seem daunting to understand at first, so let’s take a closer look at each type of tax, what it includes, and how to calculate it.
What Are Payroll Taxes?
A payroll tax is a tax on employee wages or salaries used to fund specific government programs like unemployment funds or Medicare. In the United States, payroll taxes include taxes that support Social Security, Medicare, federal unemployment, and state unemployment programs.
Who Pays the Payroll Tax?
Some payroll taxes are paid for by both the employee and the employer. These include Medicare and Social Security taxes, also known as FICA taxes (named after the Federal Insurance Contributions Act, which created them).
For FICA taxes, employers and employees split the burden equally. Employers withhold the employee’s half of the taxes from paychecks and send the money to the federal government.
In contrast, employers are fully responsible for the Federal Unemployment Tax Act (FUTA) contributions.
In most states, employers are also fully responsible for State Unemployment Insurance (SUI) taxes, which are also referred to as State Unemployment Tax Act (SUTA) contributions. However, each state sets its own wage base (the amount of wages the tax applies to) and whether or not there’s an employee contribution.
That said, employers only need to pay these payroll taxes for W-2 employees. In other words, you don’t have to pay FICA or unemployment taxes on money paid to independent contractors who use a 1099-NEC.
How To Calculate Payroll Taxes
In most cases, FICA taxes are a flat rate of 15.3% total split by employer and employee, each paying 7.65%. But you may need to make adjustments for any employee that makes more than $147,000 per year.
Here’s how the payroll tax rates break down for each category:
- Social Security: 6.2% for the employer and the employee, which applies to the first $147,000 in wages.
- Medicare: 1.45% for the employer and the employee. Employers must withhold an additional 0.9% once an employee’s cumulative wages go over $200,000 in one year.
- FUTA: 6% on the first $7,000 paid to each employee during the year, which is paid fully by the employer. However, if your state has unemployment taxes and you pay them on time, you receive a 5.4% credit, which brings your FUTA rate down to 0.6%.
- SUI/SUTA: Percent and wage base varies depending on the state in which the employee resides. New employers often pay a flat rate for a few years and then move to a rated schedule based on how much they’ve contributed to the state’s UI fund.
Let’s take a closer look:
The Social Security payroll tax has a wage base limit of $147,000, which means the tax only applies to each employee's first $147,000 wages. Once an employee’s cumulative wages exceed $147,000, the Social Security tax doesn’t apply for the rest of the year.
On the other hand, Medicare taxes have a threshold of $200,000 for the 1.45% rate. Once an employee’s cumulative wages exceed $200,000, the employer must withhold an extra 0.9% for Medicare. In other words, the employee’s tax rate becomes 2.35% on wages over $200,000. Employers don’t have to match the additional Medicare tax, so your rate stays flat at 1.45%.
Payroll Tax Example
Let’s take a look an example based on employees Jim and Angela. For these examples, we’ll say that you’re a new employer in California, which has a 3.4% SUI rate on the first $7,000 of wages paid to each employee.
Say Jim earns $60,000 per year, paid out twice each month.
Here’s how FICA tax withholding will look on his pay stub:
Gross wages: $2,500
Social Security tax withheld: $155 (6.2% of $2,500)
Medicare tax withheld: $36.25 (1.45% of $2,500)
Total FICA taxes withheld: $191.25
Net wages after FICA taxes: $2,308.75
Based on Jim’s gross wages of $2,500, the employer’s portion of payroll taxes on his first paycheck is as follows:
Social Security tax (employer’s share): $155 (6.2% of $2,500)
Medicare tax (employer’s share): $36.25 (1.45% of $2,500)
FUTA tax (assuming employer receives 5.4% SUTA credit): $15 (0.6% of $2,500)
SUTA tax: $85 (3.4% of $2,500)
Total employer tax burden: $291.25
Once Jim’s cumulative gross wages exceed $7,000, you will no longer have to pay FUTA and SUTA taxes for that year. You will only be responsible for the $191.25 of FICA taxes then.
Since Jim’s cumulative wages don’t reach the $147,000 wage base limit for Social Security or the $200,000 threshold for Medicare, his FICA withholdings will stay the same throughout the year.
Payroll software like Hourly automatically deducts the right amount of FICA and unemployment taxes from each employee’s earnings, so you don’t have to worry about remembering all the wage limits and thresholds.
Self-employed individuals, such as freelancers and independent contractors, pay both the employer and employee portion of payroll taxes. Since they’re not on a payroll, this tax is called the self-employment tax (SE tax).
However, independent contractors do not contribute to federal or state unemployment funds since they are not eligible for traditional unemployment benefits.
What Are Income Taxes?
Income taxes are paid on money earned from various sources, including wages, capital gains, and rent payments. Unlike payroll taxes that support specific government programs, income taxes fund general government activities. Income taxes can be used to pay for costs like government employee salaries, infrastructure projects, and defense.
As an employer, you do not have to pay for any of your employees' income tax, but you usually have to deduct income taxes from their paychecks.
Payroll tax and income tax are separate deductions. Payroll tax is not included in income tax. However, both are considered employment taxes.
How To Calculate Income Taxes
The U.S. uses a progressive tax system for its income tax rate, which means the more you make, the more you’re taxed. So once your income gets into a higher tax bracket, the money that specifically falls into that bracket gets taxed at a higher rate.
For example, the first tax bracket for single filers is $0 to $9,950 of taxable income, which is taxed at 10%. The next bracket is $9,951 to $40,525 of taxable income, which is taxed at 12%.
So, if an individual has a taxable income of $40,000 for the year and their filing status is single, their income taxes would be:
- 10% of the first $9,950 = $950
- 12% of the remaining $30,050 = $3,606
- Total income tax = $4,556
Instead of paying 12% on their whole income, the individual pays 10% on the first bracket and 12% on the amount of income that qualifies in the second bracket.
Methods for Withholding Income Tax
You can use two methods to calculate the taxes withheld from each employee’s paycheck: wage bracket and percentage.
You can find instructions for both methods using IRS Publication 15-T, Federal Income Tax Withholding Methods. Both methods use information from your employee’s pay stub and their W-4 Form or Employee’s Withholding Certificate.
You should have employees fill out IRS Form W-4 during their onboarding process and before you send their first paycheck since it tells you how much income taxes to deduct from their pay.
We recommend the wage bracket method since it requires fewer calculations. However, if you have an employee that earns a higher salary or has more than 10 allowances on their W-4 form, you might have to use the percentage method.
Either method you choose, manually calculating income tax withholdings for each employee is tedious work. Instead, you can use payroll software like Hourly that automatically organizes W-4 forms and calculates and submits income tax deductions for each pay stub.
You’ll also need to follow any state and local income tax instructions that apply to you, so check those local departments of revenue for that info. California, for instance, requires that employees also submit Form DE 4 for state income tax withholding. Or, let Hourly do all that for you (which it does!).
Income Taxes for Self-Employed Individuals
People who work as freelancers or independent contractors don’t receive employee pay stubs where FICA and income taxes are automatically withheld. Instead, self-employed people must pay estimated income taxes throughout the year and report their estimated payments when filing their tax returns.
Each quarter, they estimate their self-employment and income tax and use them to make payments to the IRS. If you’re self-employed, you can reference the Self-Employed Individuals Tax Center on the IRS website or work with a Certified Professional Accountant (CPA) for help with making estimated tax payments.
Final Thoughts: Payroll Tax vs. Income Tax
Payroll tax and income tax are both examples of employment tax since they are based on employee wages.
Payroll taxes are used to fund specific government programs, and in the U.S., they include contributions to Social Security, Medicare, federal unemployment funds, and state unemployment funds.
On the other hand, income tax is used to pay for government activities, such as government employee salaries and infrastructure projects.
Calculating tax withholdings can be challenging, especially for small business owners with several employees. The good news is that you can make paycheck withholdings easier by using a payroll software solution like Hourly that automatically calculates and withholds taxes for you.
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