What Are Payroll Taxes and How Do They Work?

While every employee receives a paycheck, it’s not always clear what makes up payroll. Luckily, building and expanding your financial literacy is easier than you think.

Of the many deductions that influence pay, payroll taxes may be the most common. Let’s explore how they work on a federal and state level, as well as how the right HR tech makes them easier to manage and understand.

What are payroll taxes?

Payroll taxes are charges employers deduct from their employees’ wages on behalf of federal, state or local governments. These taxes help fund essential public programs — like Social Security, health care and unemployment benefits.

Are payroll taxes mandatory?

Payroll taxes are mandatory in several countries, including the U.S. This means employers are legally obligated to withhold and pay these taxes based on their employees’ wages and salaries. Noncompliance with these requirements can carry severe legal and financial penalties.

What are the types of employer and employee payroll taxes?

Taxes can be confusing, and that’s especially true of payroll taxes. At the same time, it’s important to understand them because they affect both employers and employees. Here are the different types of payroll taxes and the various impacts they have on workers.

Federal income tax

Federal income tax is the money taken from employees’ income and sent to the government. It’s an integral part of the U.S. tax system and a significant source of federal revenue. The amount taken out of our checks depends on:

• how much money we make
• our tax filing status
• the information we provide the IRS with on our Form W-4s

In the U.S., income tax is what’s known as a progressive tax, meaning the more money we make, the higher the tax rate we pay.

Federal Unemployment Tax Act tax

Taxes from the Federal Unemployment Tax Act (FUTA) are paid by employers to fund state workforce agencies. These taxes play a crucial role in providing unemployment compensation for workers who lose their jobs.

Social Security and Medicare tax

The Federal Insurance Contributions Act (FICA) tax is made up of two main parts: Social Security and Medicare taxes. Both employers and employees are responsible for paying these taxes at a fixed rate. There’s an income limit on Social Security taxes, but Medicare taxes apply to all earnings, with an additional surtax for high earners.

State withholding tax

On top of federal taxes, many states impose their own income taxes, which are deducted from employee paychecks. However, the rates and rules differ significantly from state to state — some states have a flat tax rate for all income levels, while others use a progressive tax system. A few states, including Florida and Texas, don’t impose any state income tax at all. To ensure appropriate withholdings, it’s important for employers to know the tax laws in the states where they operate.

Local tax

In addition to federal and state taxes, some cities and counties impose their own local taxes. These taxes can have different purposes, from funding local schools to transportation infrastructure and other municipal services. The rates and rules for local taxes can also vary greatly, even within the same state. Local taxes are usually a smaller percentage of an employee’s paycheck, but they’re still important to consider when processing payroll in certain areas.

What is FUTA?

FUTA is a federal law in the United States that requires employers to pay a payroll tax. The funds collected from this tax are used to finance state workforce agencies, which provide unemployment compensation to workers who have lost their jobs. The FUTA tax, along with state unemployment systems, plays a vital role in supporting workers during periods of unemployment.

What employers are exempt from FUTA taxes?

Some employers are exempt from paying FUTA taxes, including:

• nonprofits
• religious institutions
• government entities

These organizations are usually covered under different unemployment insurance systems. Additionally, small businesses that pay less than $1,500 in wages within a calendar quarter or have household employees working less than a specified number of days in the calendar year could also be exempt from FUTA taxes.

What is FICA?

FICA is a law in the United States that requires employers and employees to pay a payroll tax. This tax is specifically used to fund Social Security and Medicare programs, which provide benefits such as retirement benefits, disability income, and health care for elderly and disabled individuals. The FICA payroll tax plays a crucial role in the social safety net in the U.S.

What employees are exempt from FICA?

Some groups of employees are exempt from FICA taxes, including:

• students employed by their school
• qualified religious sect members
• certain non-U.S. residents on temporary visas

Government employees enrolled in alternative retirement systems could also be exempt from FICA.

How do employer payroll taxes work?

Employer payroll taxes are mandatory contributions that businesses must pay based on the salaries and wages they pay to their employees. These taxes are separate and additional to the amounts withheld from employees’ paychecks.

FICA taxes are a significant component of employer payroll taxes, which includes contributions to Social Security and Medicare, and employers are required to match the amount withheld from the employee’s wages for these programs, essentially doubling the contribution to these social programs.

What are the requirements for payroll tax withholdings?

Federal and state regulations require that all employers withhold payroll taxes. These deductions require businesses to accurately deduct specific amounts from their employees’ salaries for tax purposes. The amount of federal income tax withheld depends on the employee’s earnings and the information provided on their W-4 form, including their filing status and allowances.

To avoid penalties and ensure the proper funding of government programs, employers must comply with these withholding requirements. That means regular updates to their payroll systems and ongoing communication with employees about their tax withholding choices.

What are the wage limits for payroll taxes in 2024?

Wage limits for payroll taxes, specifically Social Security taxes, are determined yearly, putting a cap on the amount of income subject to this tax. For 2024, the wage base limit for the Social Security tax is set at $168,600. This means that only the first $168,600 of an employee’s income will be subject to the 6.2% Social Security tax.

There is no wage limit for Medicare tax, and all covered wages are subject to Medicare tax at a rate of 1.45%. However, high-income earners could be subjected to additional surtaxes.

Payroll tax exemption scenarios

There are certain situations where some types of income or specific groups of people are exempt from paying payroll taxes. In the U.S., for instance, if an employee contributes to certain retirement accounts, such as a 401(k) or 403(b), their contributions could be exempted from federal and state income tax withholdings. (Social Security and Medicare taxes, however, are still applicable.) Also, some educational institutions, religious organizations and nonprofit entities may not have to pay the employer portion of FICA taxes for their employees.

In some situations, people could be exempt from certain taxes, such as FICA taxes. For example, students who work at their university may be exempt from FICA taxes if their employment is a crucial part of their educational experience. Also, some non-U.S. residents, like those on J-1 or F-1 visas, may not have to pay some payroll taxes, at least for a limited period.

What are the payroll tax rates?

Payroll tax rates in the U.S. have two main components: FICA and FUTA. For the Social Security portion of FICA, the employer and employee contribute 6.2% each, up to 12.4% on an employee’s income below a certain limit. This limit is adjusted annually. The Medicare portion of the FICA tax rate is 1.45% each for both employer and employee, which adds up to a total of 2.9%. Unlike Social Security, there’s no income limit for Medicare, but high earners could be subject to an additional 0.9% Medicare surtax, which is solely paid by the employee.

FUTA, which funds unemployment compensation programs, has a standard tax rate of 6% on the first $7,000 of each employee’s earnings. But if the employer pays state unemployment taxes on time and in full, this rate can be reduced to 0.6%.

At the state level, payroll tax rates vary greatly; certain states require employers to withhold and remit income taxes on behalf of their employees. Other states also impose unemployment taxes and other state-specific payroll taxes. These rates can vary based on factors like the employer’s industry, the company’s claims history for unemployment benefits and state-specific regulations.

Payroll tax vs. income tax: the difference

Payroll tax and income tax differ significantly in their purpose and how they’re levied. Payroll taxes are primarily used to fund government programs like Social Security and Medicare. They’re a fixed percentage of an employee’s wages, and they’re usually divided between the employee and employer.

Income tax is levied on an individual’s total income, including wages, salaries and other earnings. But unlike payroll taxes, income taxes aren’t explicitly designated for specific programs. They’re progressive taxes collected by both federal and state governments (in states that impose income taxes) and are used to fund a wide range of government services beyond Social Security and Medicare — including things like education, infrastructure and defense.

Calculating income tax is more complex than the flat-rate payroll tax, mainly because it’s based on various factors like income levels and filing status.

What types of payroll services file taxes for your business?

Many types of payroll services exist, ranging from full-service providers to specialized software. These services are equipped to handle payroll tax calculations, withholding and remittance to federal, state and local agencies. Other features include automatic tax updates, year-end reporting and compliance support, among others. But given the differences between HR software, it’s key to identify and secure what your business truly needs.

Paycom’s payroll tax management

Paycom’s payroll tax management software simplifies and automates payroll tax:

• calculations
• filing and payment
• compliance with federal, state and local tax regulations

Our tech also tracks changes in tax laws and rates, adjusts withholdings and contributions accordingly, and automatically files the necessary paperwork with the appropriate tax agencies, reducing the risk of errors and late payments.

From a reporting standpoint, our software provides real-time access to payroll tax data, giving HR a transparent view of all payroll tax activities and ensuring you have the necessary documentation for audits and compliance checks. And it integrates seamlessly with all the other HR processes in our single software, from employee onboarding to payroll processing.

Check out Paycom’s resources to learn about other foundational HR topics and more.