What Are Payroll Taxes? And How Do You Calculate Them?
Most people don’t like the idea of taxes in general, not to mention the excruciating minutia of what goes into calculating how much to pay the government and when. And if you do like those things, then you are probably an accountant or a payroll tax expert already. God bless you, you don’t need this article. However, if you are a small business owner who is entering the world of payroll, understanding payroll taxes can feel daunting. It’s true: there’s plenty to learn and making a mistake can result in costly fees. Using payroll software might take the guess-work out of the process and do the calculations for you, but it’s still important to have a rudimentary understanding of payroll taxes, especially if employees have questions about their paychecks.
In this post, we’ll cover what payroll taxes are, who’s responsibility it is to pay them and when, how to calculate them, and more.
Table of Contents
What Are Payroll Taxes?
Payroll taxes are the money an employer withholds from an employee’s earnings to pay taxes to the state and federal governments. How much an employer takes out and sends to the government is based on the employee’s salary and wages, and it is the employer’s responsibility to manage these taxes. There’s only one exception: 1099 contractors are in charge of their own taxes! Contractors, freelancers, and small business owners pay a self-employment tax which is the equivalent of employee/employer payroll taxes.
Payroll taxes make up a substantial part of government revenue and are the second-leading money generator for the United States. (And we can often look to payroll in America as indicators of how our economy is growing or receding, too, as payments reflect growing trends in hiring and stagnation.) When an employer runs payroll, the process involves calculating the employee’s net pay. Net pay is the take-home paycheck employee’s receive on payday, and how you calculate that net has to do with how much state and federal taxes you, as the manager of the payroll, take out, collect, and pay to the appropriate agencies. It’s a detail-oriented process that has multiple opportunities for missteps and steep penalties for mistakes.
Bear in mind that when someone says “payroll tax,” they are lumping together all of the various taxes paid out of a person’s paycheck for services, but in the next section I’m going to breakdown where those payroll taxes go.
Types Of Payroll Taxes
When an employer removes taxes from an employee’s paycheck, that money is earmarked for state and federal services. Here’s how payroll taxes breakdown individually:
- Federal Income Tax Withholding: Federal income tax is based on income level and the rates are progressive, meaning that as you make more income, your rates move, and your income tax increases as you travel up the tax brackets. There are currently seven tax brackets that tax income at: 10%, 12%, 22%, 24%, 32%, 35% and 37% as income increases.
- Social Security Tax: This tax is also called the Old Age, Survivors, and Disability insurance, and it’s a flat-rate tax of 12.4% of taxable income. Both the employee and the employer are responsible for paying half (6.2%) of the social security tax.
- Federal and State Unemployment Taxes: The Federal Unemployment Tax is a mandatory tax paid quarterly versus monthly. State requirements differ widely.
- Medicare Tax: This tax is also a flat rate of 2.9% with the employer and the employee splitting the cost at 1.45% each.
- State Income Tax Withholding: There are currently seven states that do not have a state income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming) but for everyone else, income taxes work similarly to federal income tax withholdings. The tax rates are very specific to each state, so check the withholding tables on the state government website where your business is located.
- Local Taxes: Local taxes are very specific to city and state. Most states have a state unemployment tax that is accounted for in this local taxes section. These taxes are based on local tax laws and the tax rates vary, so small business owners need to check/verify those taxes through the state’s tax department.
Payroll Tax VS Income Tax
|Payroll Taxes||Income Taxes|
|Payroll taxes include FICA taxes (social security and medicare) and local taxes withheld, and the additional percentages provided by the employer.||VS||Income tax specifically refers to the federal, state, and local income tax rates|
So, running taxes for your payroll involves collecting both payroll taxes and federal/state income taxes. When people say “payroll taxes” they are providing an umbrella term for all collected tax, but the term “payroll tax” refers to FICA taxes (social security and medicare) and local taxes withheld from an employee’s paycheck, plus the additional percentages provided by the employer. Income tax specifically refers to the federal, state, and local income tax rates. Even though the two are joined together in one lump, payroll taxes are specifically earmarked for certain programs. Income tax, on the other hand, is delivered to its respective federal or state governments and is used to manage the budget.
Who Pays Payroll Tax?
The burden of managing payroll and sending payroll tax payments is on the company, and the burden for paying those taxes falls on both the employee and the employer. Each state has different regulations and requirements for how state income tax is paid to the government, and the federal government collects payroll taxes quarterly.
Employer Tax Responsibilities
Okay. You are a small business owner and it’s time for payroll. What tax responsibilities do you have?
- Social Security: You will pay your half of the 6.2% and you will withhold 6.2% from wages for your employee’s portion.
- Medicare: You will pay your half of the 1.45% and you will withhold 1.45% from wages for your employee’s portion.
- Federal Unemployment Tax: This tax is employer-paid and the current rate is 6% on the first $7,000 earned by an employee.
If you are self-employed or working under contract, you are the employer and the employee and it’s your responsibility to pay for both sides of the payroll taxes. That means that contractors need to withhold the full 12.4% for social security and 2.9% for Medicare, and withhold their own state and federal income taxes (saving 15-20% of each check to cover these taxes is the recommended practice). Some states also charge additional taxes for small businesses that become the responsibility of a contractor, as well. When contractors file their taxes, they will pay their portion of these taxes then.
When Are Payroll Taxes Due?
Once you have collected the payroll taxes for your small business, they are due on either a monthly or semi-weekly deposit. Semi-weekly deposits are primarily required just for large businesses with a large payroll tax revenue, so it is most probable that you will deposit your withholdings monthly. Payroll taxes are due on the 15th of every month (unless that falls on a weekend, then the next available Monday).
If you are self-employed, you most likely will file estimated quarterly taxes (although some states accept yearly payments if you make under a certain amount). Check your state’s specific rules and tax brackets for the most accurate information.
How To Calculate Payroll Taxes
Calculation of payroll taxes uses all the great basic math skills: multiplication, addition, percentages. Be aware that if you make a mistake or are late processing a payment, the government likes to slap fees around. (I mean, no doubt, fees are a source of revenue for the government, too.) While you can do payroll calculations by hand (and many do, including an adorable 80-year-old woman on Facebook who chastised me for suggesting someone run payroll using anything other than their head, a pencil, some paper, and the numbers), there are many great payroll software options that can do this part for you: Gusto, Square, Paychex, and ADP are all reputable companies that you can use to outsource payroll.
However, maybe you really want to tighten the budget and only have a few employees and you’re not gonna let me convince you to give the computers their chance at this one. Okay. Pencil. Paper. Calculator. Spreadsheet with equations, maybe?
You’ll need to know how many times you are paying/withholding taxes from your employees before you can run payroll, so determine whether you are running payroll, weekly, biweekly, or monthly. Then you will need to decide if you’d like to pull taxes using the wage bracket system (recommended by most tax experts for small businesses) or the percentage method (not recommended for small businesses attempting payroll on their own).
When you onboard employees, you will have them fill out a W-4. You will use that W-4 to note the employee’s withholdings and whether they are filing single/jointly/head of household. This is the data you need to calculate federal income taxes. The following image is from the IRS Publication 15 for the 2019 tax season and gives the step by step numbers for calculating the federal income tax withholdings through either method.
After you withhold the money for federal income taxes and any additional pre-tax deductions (retirement, worker’s compensation, healthcare), then you calculate the FICA (social security and Medicare) taxes. To calculate the social security tax, you will take your employee’s gross pay (the amount your employee receives before payroll taxes are removed for that pay period) and multiply it by .062 — the product is the amount of money to be withheld from the paycheck and matched by the employer.
You would do the same thing for the employee’s portion of Medicare by taking the gross pay for the pay period and multiplying it by .0145%. The product is the amount you’ll withhold and match for Medicare.
All state and local taxes are calculated on a state-by-state basis.
How To Report & Pay Payroll Taxes
When you run payroll, calculating the taxes and discovering your employee’s net pay (aka their take-home pay or the amount they make after payroll taxes are removed) is only the first part of the process. After you’ve run your payroll numbers, you face the important task of getting those taxes into the right hands and accounting for your payroll to the government. As a small business owner, it is your responsibility to:
- Withhold all payroll taxes and submit them on time (the 15th of every month, or next available business day) to state and federal agencies.
- Report income, withholdings, matching of payroll taxes to the government quarterly.
- Keep records of yearly payroll for state and federal reporting agencies.
- Send W-2s and 10-99s to employees and contractors listed with the correct amounts of their gross/net pay and tax withholdings.
When you have the monthly deposit to submit, you must submit the funds electronically (barring special circumstances allotted to small businesses only) using one of the following methods: via a third-party (through a software/payroll service like ADP, Gusto, or Paychex); through your bank’s Automated Clearing House (ACH) network; or by the Treasury Department’s free Electronic Federal Tax Payment System online/over the phone.
Some small businesses, especially those with low liability, can opt-in to a yearly payroll payment. This requires filling out a Form 944. Check the government’s website to check for current eligibility requirements.
Your Federal Unemployment Taxes are due to the government quarterly. Form 941 is your guide to reporting income, withholdings, and payroll taxes to the government, and the tax forms are due on the last day of the month after the end of the quarter. For example, quarter one ends March 31 and the report is due by April 30. And at the end of the tax year, you have until January 31 to deliver the necessary tax forms to your employees, former employees, and contractors, so they can file their taxes correctly.
For both small business owners and the self-employed, it is imperative to maintain impeccable records of your state and federal payroll taxes, whether by hand in a notebook, in an old spreadsheet document, or by using online software.
Payroll Tax Penalties
Alright, here’s the big scary number: 100%. If you fail to withhold the proper amount from your employees, you the employer are 100% liable and will need to furnish the missing monies from your own pocket in addition to any legal penalties and fees you face. Look, people get real serious when you don’t give them the correct money owed. Also, these funds go toward employee services, so sometimes your employees can’t access these services if the account is behind. Employer error is costly because tax laws say that the onus for accuracy is on you, the business owner. And if you can’t pay those fees? That trickles down into every aspect of your business in a cycle: higher consumer costs, decreased employee wages, a hiring freeze. Not to mention that it erodes the trust between an employer and an employee.
If you don’t pay your payroll taxes on time, every month, you incur a 2% penalty for 1-5 days late; 5% penalty for 6-15 days late; 10% for 16+ days late or within 10 days of first hearing from the IRS. The maximum is 15%.
Also, the government doesn’t care if you outsource these jobs — if a third-party isn’t paying on-time (your payroll service or your bookkeeper), you still hired them and will receive the penalty all the same.
There are other ways you can be penalized, too, like if you miscategorize employees or you make an error on your reporting. There are too many potential errors to explain them all, so it’s important small business owners meet with tax attorneys or other tax experts for a full understanding of the myriad ways things can go off the rails.
Payroll Tax Deductions
But hey…those Statutory Payroll Tax Deductions (all the things we just talked about above: federal and state income tax, social security, Medicare, unemployment taxes) are not the only payroll tax deductions you’ll need to make as you process payroll. In addition to the mandatory deductions, you also have Voluntary Payroll Tax Deductions. These are things like health care, retirement benefits, worker’s compensation, or any other pre-tax deductions. As a small business owner, you might offer some of these programs and benefits but some of the cost can (and does) trickle down to employees.
Nothing concludes this post better than this: payroll taxes are complicated. But, they don’t have to be.
If you have a handful of employees, and you want to calculate payroll taxes yourself, then yes you can! You now know the basics of which payroll taxes you are responsible for, how to calculate them, and how and when to pay them. People have been processing payroll manually for longer than they haven’t been.
Or, you can opt for payroll software to help handle the calculation for you. Even if you do have a software program or an online program helping you, it’s great to know what those numbers mean and where that money is going. There are also free online calculators to use in lieu of a software program, or a regular calculator, or an abacus. All in all, these payroll taxes — while they may be an added stressor to the laundry list of small business owner responsibilities — are what pay into great social programs and protections. The most important thing to remember is that rates and guidelines can change yearly depending on inflation and tax laws, so keep up with current literature on the tax brackets from the IRS Forms. Know your state’s laws, file accurately and promptly, pay on time, and report on time. And if you want someone else to do it for you, check out our reviews of some of the leading payroll service vendors out there: Gusto, Square, ADP, Paychex.