Many Americans are not familiar with the differences between payroll taxes and income taxes. When most employees receive their paycheck, they recognize their tax deductions, but knowing exactly how much goes to each location isn’t critical. However, for business owners, familiarity with payroll taxes and income tax is crucial.
What are payroll taxes?
Simply put, the payroll tax is a tax that an employer withholds from an employee’s salary, wages, or tips. The employer then remits the withheld amount to the government on behalf of its employees.
In the United States, there are four main types of payroll taxes:
Medicare
Payroll taxes paid to Medicare are diverted to two separate trust funds. The first fund is known as the Hospital Insurance Trust Fund. The second fund is the Supplemental Medical Insurance Trust Fund,
Before learning about the role of each trust fund, it’s important to recognize that Medicare is divided into four different parts, each of which helps with different types of medical costs. These parts are known as A, B, C, or D.
– Medicare Part A helps pay for hospital care, inpatient skilled nursing care, and, in some cases, home care.
– Medicare Part B helps pay for the costs of medical services, such as lab tests and exams, outpatient care, X-rays, ambulance service, and more.
– Medicare Part C helps pay the costs of hospitals, medical facilities, and services, but taxes on wages are not paid in Part C. Part C plans are only available through private insurance companies.
– Medicare Part D helps pay for prescription drugs.
The Hospital Insurance Trust Fund pays for Medicare Part A and associated administration fees. The Supplemental Health Insurance Trust Fund helps pay for Medicare Parts B and D and other costs of administering the Medicare program.
Social Security
Social Security was passed in 1935 to provide a safety net for the retired and disabled. The Social Security Act of 1935 provided an exemption for people with high incomes, but this exemption has been replaced by a limit that goes up and down based on wages. This limit is called the Salary Base Limit.
As in the case of Medicare, all funds paid to Social Security are diverted to two different trust funds. The first is the Old Age and Survivors Insurance Trust Fund (OASI), which pays retirement and survivor benefits. Social Security’s second fund is the Disability Insurance Trust Fund, which covers disability benefits. These funds are managed by the Secretary of the Treasury, the Secretary of Labor, the Secretary of Health and Human Services, the Commissioner of Social Security, and two public trustees.
Federal unemployment
The Federal Unemployment Tax Act (FUTA) imposes a federal tax on employers that is used to help fund state labor agencies. FUTA covers a portion of the cost of administering unemployment insurance and employment service programs. It also provides a fund that states can borrow from, if needed, to provide unemployment benefits.
Entrepreneurs pay federal unemployment tax; the IRS explicitly states that employers cannot deduct this cost from their employees.
Federal income tax
Federal income tax is a progressive tax that is levied on employee wages, salaries, or tips. Most employers deduct federal income tax payments.
Contributions to Medicare and Social Security make up the Federal Insurance Contributions Act (FICA). Employees pay Social Security and Medicare taxes through payroll deductions.
The employee pays a tax of 6.2% for Social Security expenses and 1.45% for Medicare. The employer must match the deduction and send the full amount to the IRS. Self-employed workers pay 15.3% of their salary, which includes both the part of the tax paid by the employer and that paid by the employee.
How much are payroll taxes?
Social Security and Medicare
For both the employer and the worker, the current Social Security tax rate is 6.2%. These add up to a total of 12.4%. The current rates for Medicare are 1.45% for both the employer and the employee, adding up to a total of 2.9%. The rates are the same because, by law, employers must match FICA contributions.
If you are a sole proprietor or run a business with no employees, you must pay self-employment income tax. This tax is calculated at a rate of 15.3%, which is equal to the sum of the company’s share of Social Security and Medicare.
Additional Medicare Tax
According to the IRS, the Additional Medicare Tax applies to an individual’s Medicare wages that exceed a threshold amount based on the taxpayer’s filing status. Employers are responsible for withholding 0.9% Additional Medicare Tax on the wages of an individual earning more than $200,000 per year, regardless of filing status. The employer must begin withholding the Additional Medicare Tax in the pay period in which it pays wages over $200,000 to an employee and continue to withhold it in each pay period until the end of the calendar year. Unlike with Social Security or basic Medicare, the employer is not required to match the employee’s contributions to the additional Medicare tax.
Salary Base Limits
The Salary Base Limit is the aforementioned Social Security earnings limit; the salary base limit is the maximum salary that is subject to the tax for that year. The base is $137,700 for all income in 2020.
There is no wage base limit for Medicare tax, as all covered wages are subject to Medicare tax.
Unemployment tax (FUTA)
The total rate to which FUTA applies is 6.0%. However, most states have a 5.4% credit. This reduces the rate to 0.6%.
federal income tax
There are two tax withholding methods for determining how much to withhold for federal income tax: percentage and wage bracket. Use the information from the employee’s W-4 form, as well as their weekly wages and frequency to calculate their federal income tax deduction.
Payroll taxes and income taxes
Many people don’t fully understand the difference between payroll taxes and income taxes. However, entrepreneurs must become familiar with the similarities and differences.
For starters, unlike payroll tax, federal income tax is not calculated at a single flat rate. Rather, a progressive tax rate applies. An employee’s salary and frequency of pay influence the amount of income tax. This amount is based on information on an employee’s W-4 form, such as filing status, dependents, and backup withholding requests. When a new employee is first hired, he or she must complete Form W-4, Employee Retention Certificate.
The main difference between federal income tax and the payroll tax is that federal income tax goes into the government’s general fund for public services such as defense, education, postal service, and transportation. FICA taxes only fund Social Security and the Medicare program.
State income tax works similarly to federal income tax. If there is a state income tax, you will give your employee a state income tax withholding form. State income tax can be flat or progressive.
In addition to the federal payroll tax, employers are also responsible for remitting state payroll and income tax on behalf of their employees.
Below the federal level, payroll tax rules differ from state to state. To help taxpayers access information for their states, the Federation of Tax Administrators has published a list of each state’s taxing authority.
Who pays payroll taxes?
At first glance, it appears that the employee and employer are splitting the payroll tax bill. It is necessary to discuss how much each party contributes because the fiscal incidence is more affected by the markets than by the laws. Some argue that the economic concept of relative price elasticity places the burden more on the employee than on the employer. But if you run a business, this nonsense doesn’t matter. It is your responsibility, as an employer, to have your payroll well configured and in order, unless you outsource it to a third party, as many companies do.
Can I outsource my payroll?
Having payroll in order is essential for any employer. However, it can also be tedious, complicated, and time-consuming, especially for smaller businesses. Plus, the IRS can be ruthless when it comes to mistakes: Filing payroll taxes a single day after the due date carries a 2% penalty. These fines can be up to 15%.
