Payroll Tax

Ultimate Guide to Payroll Tax: All You Need to Know

What is payroll tax and what does it include? Here's a guide designed to help you understand payroll tax basics and how they can affect your business.

Stefana Zaric
Written by Stefana Zaric
November 18, 2021
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When building a workforce for your business, there's one thing to consider when agreeing with your new hire upon an annual salary. Your employee's net pay isn't your total cost because as an employer, you're required to provide several employee benefits to your people.

Other than that, you also need to cover a few types of taxes for your workers. One of them is payroll tax.

This guide is designed to help taxpayers understand payroll tax basics and how they can affect your business. It'll provide general information on the payroll tax, how it impacts your company, why you need to pay attention to this important issue, and what steps you can take to minimize its impact.

What Is payroll tax?

A payroll tax is a type of tax that's taken out of an employee's paycheck. It includes taxes that are withheld from an employee's paycheck and the employer portion of payroll taxes paid to federal, state, and local governments. To calculate the accurate amount of tax to withhold from the employee's salary, employers need the form W-4, which employees are expected to fill in and submit in a timely manner.

A note: If an employee submitted it in 2020, there's no need to do it again, unless there's been a change that may impact the tax - if they've changed their marital status, for example.

The Federal Insurance Contributions Act mandates that both the employer and employee should contribute toward the Medicare and Social Security programs.

The payroll tax applies to your entire payroll, not just the amount you pay in wages or salary to employees each year. Employers must withhold income taxes from an employee’s earnings unless they certify their exemption under their country’s specific tax regulations. 

The state may also require you to withhold personal income taxes from wages.

Some common types of state payroll tax include:

  • Federal Income Withholding Tax (FITW)
  • Social Security Administration and Medicare Taxes (SSM & Medicare)
  • State Income Tax Withholding/Employee's Contributions for SSI, etc
  • State Unemployment Tax (SUTA)
  • Federal Unemployment Insurance Taxes/Employer's Contributions for FUTA

Note that these types may vary from one country to the other. For example, in the United Kingdom, payroll taxes are levied on an employee's wage to finance social security. These include PAYE income tax and Employees' National Insurance contributions for those who work in Britain.

The COVID 2019 pandemic impacted the amount of state income taxes that governments collected. Ultimately, most countries had to reduce the amount of personal income taxes and other taxes due to the coronavirus pandemic that affected jobs and businesses.

It's also important to remember that some countries may exempt you from tax payments if you operate a nonprofit. Old-age might also determine how much tax credit you're entitled to every year. 

People eligible for disability insurance may also be exempted from state payroll taxes. You can also request a child tax credit.

As mentioned, you may get a tax credit depending on the tax year or your type of organization (self-employed, employed, pandemic, etc.). Be sure to check with your government to see how much employment tax you should pay every tax year.

How does payroll tax work?

Employers typically track the tax amounts that they withhold from an employee's pay and then report this information to their state unemployment agency, which calculates any additional employer payroll taxes owed.

The IRS requires employers to file additional forms with their annual tax return for reporting amounts they withheld from employee wages. Employers must also report the employer portion of FICA taxes and any other payroll-related items that apply to them.

What does payroll tax include?

You can include several different taxes under the umbrella term payroll tax.  These include but are not limited to the following.

  • Income tax withholding on wages and salaries paid to employees
  • Social security taxes are withheld from employee's paychecks, including both employer and employee portions of social security tax amounts due. Employers also have to match this amount for each worker who earns more than a specific amount of income.
  • Medicare taxes that are withheld from employees’ paychecks.
  • Unemployment insurance tax on the employer’s contribution rate for employees in most states and unemployment compensation contributions. Some state unemployment rates also consider an individual worker’s earnings, experience, and/or employment status.
  • State unemployment insurance tax on the employer’s contribution rate for employees in most states. This is usually based upon hours worked by each employee, or their earnings within a certain time period.
  • Federal Unemployment Tax Act (FUTA) taxes are paid to the federal government. Some employers receive an offset credit for state unemployment taxes paid. Additionally, employers are eligible to receive a credit of wages per worker against their FUTA tax if they qualify under the eligibility requirements.
  • Workmen’s compensation insurance premiums cover work injuries or illnesses that happen while employees are on the job. Employers in most U.S states must carry this insurance for their workers.

What is payroll tax used for?

Governments use payroll taxes to help cover the costs of various public programs, including Social Security and Medicare. On the other hand, local governments tend to use payroll taxes for specific purposes, such as public transportation or infrastructure repairs.

These programs help to ensure that people have a living wage when they retire to live comfortably in their golden years.

What are the disadvantages of payroll taxes? Although an employer needs to pay their share of the social security tax on time, this is often hard, especially if there are many employees.

How much is the payroll tax?

Payroll tax rates are determined by the law and may differ from one country to the other. Many states or regions in a country may have their versions of the taxes you pay as payroll.

In the United States, employers pay four federal payroll taxes, namely:

Social security: 12.4% deducted on employee earnings as per the IRS limits. You pay half (6.2%), while your employee pays the other half.

Medicare: 2.9% of your employee earnings. Half the earnings come from you, the other half from your workers. However,  your employee's tax rate tends to increase by 0.9% when their earnings pass the annual $200,000. But remember that there might be additional medicare tax depending on your wage base, earned income, and type of insurance policy.

Unemployment tax: You pay up to 6% of the first $7,000 your employee earns. Ultimately, you pay for everything here. Thankfully, the rate can drop to as low as 0.65 if you pay your taxes on time.

Income tax: It can be paid entirely from an employee’s wages, but the rate changes period depending on how much they earn. Plus, you might want to claim allowances for them which helps to lower the tax bill even more.

Federal income tax is the most complex of all three Social Security and Medicare benefits, but it also represents how much an employee makes. They may be able to claim allowances, which lower their taxes for them not to pay a high rate or even owe anything at all.

The United States has one federal system. Each state handles its economic issues such as taxation; however, certain regulations apply to finances like social security numbers (SSN).

When you fill out your payroll tax forms during an interview or when you’re getting hired at a new company, your employer must know how much money they should take from each paycheck for tax purposes. 

The more allowances you claim on this form, the less money you will receive from each paycheck. 

Ultimately, the more allowances you claim, the less money your employer will have to pay in payroll taxes at the end of the year.

What about deductions?

Most employers will deduct any expenses they incur for their employees from an individual's paycheck - whether that be a fee for a uniform or a certain amount for gas to get them to work.

In some cases, there may be deductions made from an employee’s earnings if they have been late for their shift, didn't come at all, or took time off without permission.

Payroll vs. income tax?

In most countries, payroll taxes are deducted from the employee’s earnings before getting your hands on it. In contrast, income tax is paid by individuals and not companies or corporations.

When are payroll taxes due?

As an employer, you must withhold payroll taxes when paying your employees every tax year. Usually, the tax is withheld from their regular paycheck and paid to the relevant authorities monthly or biweekly, or on a monthly or biweekly basis.

You may need to spend additional money if that employee’s pay exceeds certain limits; in case of failure, they will be subject to penalties like fines and even a prison sentence!

However, you can always file for an extension in case of unexpected issues.

Who pays payroll tax (employee Vs. contractor)?

Generally, the one paying your payroll tax will depend on whether you are an employee or contractor.

If you’re employed by someone else, it's their responsibility to cover the payroll tax. On the other hand, independent contractors need to take care of the social security benefits on their own and cover the self-employment tax.

It's also important to note that if the contractor works over a certain number of hours during any given period (usually 30 days), they’re considered an employee and subject to different employment laws.

How can I reduce payroll taxes?

There are several ways that you can reduce the amount of money your business pays in tax obligations. Here is a list of helpful tips:

  • Make sure you file and pay all estimated quarterly payments on time. Failing to do so could result in a penalty and interest charges.
  • File your tax returns even if you don't owe any taxes. Failing to file can result in penalties and fines. Some states charge their filing fees, while others impose additional penalties for late payments or nonpayment of tax obligations.
  • Keep accurate records, such as receipts, invoices, and other documentation. Save receipts, invoices, or journal entries for all business expenses you incur in conducting your company’s operations. This can include items like office supplies, equipment purchases, and employee compensation.
  • Keep detailed records of each deduction that you make on an employee's paycheck to ensure they're not overpaying on their taxes and to ensure you're not making errors. Also, make sure that your employees know their taxable wages.
  • Do the same for your business expenses by keeping accurate records of all income generated from operations. Also, record any outflow costs that may have been deducted on an employee’s paycheck or elsewhere to avoid overpaying payroll taxes or having inaccurate tax reports filed.
  • Take advantage of tax deductions and other financial incentives or programs that your business may qualify for. These can include federal, state, and local government credits as well as employer-sponsored retirement plans like 401(k)s (which allow you to defer income until later in life), health insurance benefits through the Small Business Health Options Program (SHOP) Marketplace and more.
  • Consider hiring an accounting firm to help reduce the amount of money your small business pays in taxes by ensuring you take advantage of all available tax deductions, credits, and incentives. 

This can also be helpful for businesses that may only hire contract workers or freelancers on certain occasions as it relates to payroll requirements. You may also want to consider hiring an accountant to help you with your bookkeeping, filing, and other tax-related obligations.

Navigate local taxes with Deel

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