What is payroll tax and how much does it cost?

Small Business Guides

5 min read

Here we take a look at what federal and state payroll taxes need to be paid, and the rules and exceptions that apply. Let’s break them down.

What are payroll taxes?

Employers are required to make several tax payments whenever they pay employees. These are known as payroll taxes. Most of the money comes out of the employee’s wage or salary, but some are paid by the employer, and some are shared.

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 ask the state tax agencies if they have any additional requirements. Do this for the state where your business is based, and the states where your employees live.

Four federal payroll taxes

The four federal payroll taxes are:

  • Social security

  • Medicare

  • Unemployment tax

  • Income tax

Many states have their own versions of these taxes so check with your state agencies.

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 your employees can claim “allowances” that lower their tax bill.

Employers are expected to deduct the right amount of income tax based on the employee’s earnings and the allowances they claim on their W-4. Slight unders or overs will be sorted out between the IRS and your employee when they complete their annual tax return.

Calculating employee income tax

You need four pieces of information to estimate income tax for an employee:

  • How often they’re paid (daily, weekly, bi-weekly, monthly)

  • Their marital status, as listed on the W-4 they fill out before starting work

  • The number of allowances they’re claiming, which is also on the W-4

  • The amount you’re paying them

There are a few methods for working out how much to withhold. One of the most common is the wage bracket method.

Wage (or salary) bracket method

To use the bracket method for calculating income tax deductions, you:

  • search the IRS website for ‘IRS withholding tables’

  • find the IRS bracket that matches your employee’s pay frequency and marital status

  • go down the rows to find the amount you’re paying them

  • go across the columns to find the number of allowances they’ve claimed

The number at the intersection is what you should deduct from your employee’s salary or wage. There are other ways to work out how much employee tax to withhold, which you can find on the IRS website.

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 staff. They are additional costs, over and above salary and wages.

Taxes and benefits

Some businesses pay benefits to their employees, such as healthcare insurance or retirement contributions. 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.

For more on benefits and garnishments, check out our guide on payroll deductions.

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 several 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 has changed on a yearly basis.