Guide

What is payroll tax?

We take a look at what federal and state payroll taxes need to be paid, and the rules and exceptions that apply.

Payroll tax on a mobile phone

What are payroll taxes?

Employers are required to make several tax payments as a result of paying employees. These are known as payroll taxes. Some of the money comes out of the employee’s wage or salary, but some are paid by the employer.

Federal versus state payroll taxes

Federal payroll taxes are the same for all US businesses. State payroll taxes change depending on where your business is, and where your employees live. Start by figuring out your federal payroll tax, then find out if the state tax agencies have any additional requirements. Do this for the state where your business is based, and the states where your employees live. A payroll professional can help with this.

Four federal payroll taxes

The four federal payroll taxes are:

  • Social security
  • Medicare
  • Unemployment tax
  • Income tax

Many states have their own versions of income and unemployment tax so check with your state agencies. It’s important you don’t forget them as payment of them is required by law.

Social security tax rate and deductions

  • 12.4% of employee earnings
  • Half (6.2%) comes out of their pay, the other half is paid by the employer
  • The tax is deducted on employee earnings up to the annual wage limit set by the IRS - this limit can increase each year

Medicare tax rate and deductions

  • 2.9% of employee earnings
  • Half (1.45%) comes out of their pay, the other half is paid by the employer
  • The employee’s tax rate increases by 0.9% when employee earnings pass $200,000 a year - there’s no increase in the employer rate

Federal unemployment tax rate and deductions

  • Up to 6% of your employee’s first $7,000 in earnings
  • It is paid completely by you, the employer
  • The rate can drop as low as 0.6% if you pay state unemployment taxes on time

Federal income tax deductions

Federal income tax is more complex than social security and Medicare. It’s paid completely from the employee’s earnings but the rate changes depending on how much they make and withholding selections they make on Form W-4. Employers are expected to deduct the right amount of income tax.

So what are employer payroll taxes?

As we’ve seen, some payroll taxes come out of an employer’s expense account rather than the employee’s salary or wages. These are the federal employer payroll taxes:

  • Social security (half is paid by the employer)
  • Medicare (half is paid by the employer)
  • Unemployment (all of this tax is paid by the employer)

You will also have employer payroll taxes at state level. Every state collects an unemployment tax, for example. And some have more than that. Check with your state agencies to see.

Keep all of the employer payroll taxes in mind when budgeting to hire people. They are additional costs, over and above salary and wages.

Taxes and benefits

Some businesses provide benefits to their employees, such as healthcare insurance or retirement contributions. Some of these have a cost to the employee and that cost is deducted from their pay.

Some of those benefits are deducted before tax is calculated (in other words, they’re tax free), and others come after. You may also be required by law to take garnishments out of an employee’s pay.

Staying on top of payroll taxes

Payroll tax deductions can change depending on an employee’s personal circumstances, such as marital status, and on the amount of money they’ve earned in a period. And because income tax rates change with earnings, you can’t easily use spreadsheet formulas to figure out what they owe from pay run to pay run.

For that reason, small businesses with employees often use payroll software to do the math. As a bonus, these types of systems also auto-fill tax returns and allow you to file online.

Whatever system you use, make sure you update employee payroll records regularly. Your employees are supposed to tell you about important changes that affect their deductions, but they may not remember to. Ask them if anything on their W-4 or state withholding forms has changed on a yearly basis. And always consult with your accountant, bookkeeper or payroll professional if you need help.

Disclaimer

Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the provided content.

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