It’s a beautiful day. You woke up with a pep in your step, had the best dang cup of coffee you’ve ever had, and you’re knocking things out of the park in your business. But then the mail comes. And you see a Failure to Deposit Penalty notice from none other than the IRS—for failing to deposit the right amount of payroll taxes. What a punch in the gut (and a surefire way to ruin a perfectly good day)!
Miscalculating payroll taxes can land you in hot water with government agencies. So, how is payroll tax calculated? Well, it depends on the tax, which makes it extra tricky for employers who run payroll manually.
Here’s the good news: You don’t have to do payroll manually. You can use payroll services (look for one with a tax filing accuracy guarantee) to calculate, file, and deposit federal, state, and local taxes. But whether you do payroll manually or use software, you should have a basic understanding of how to calculate payroll taxes.
How Is Payroll Tax Calculated?
Again, how you calculate payroll tax withholding depends on the tax. For example, federal income tax is progressive, while FICA tax is a flat percentage.
In this article, I’ll go over the types of employment taxes and how to calculate each:
- Income tax
- FICA tax
- Unemployment tax
- Other taxes
1. Income Tax
Income tax isn’t technically a payroll tax, but it’s universally lumped in with them because, well, it is part of payroll tax withholding (details, details). But unlike true “payroll taxes,” income tax is something only your employees pay.
All employers are responsible for withholding, remitting, and reporting employee income taxes. These taxes may differ based on where your employees live and work. Here are three types of income taxes:
- Federal income tax
- State income tax (if applicable)
- Local income tax (if applicable)
Federal income tax
Federal income tax is a progressive tax that employers must withhold from employee wages. Like a true progressive tax, the amount you withhold depends on an employee’s income, along with other factors like their filing status and pay frequency.
To determine an employee’s federal income tax withholding, you need information from Form W-4, Employee’s Withholding Certificate. The employee fills out the W-4 and gives it to you (make sure to retain the form in your records for at least four years). Form W-4 tells you which IRS Wage Bracket or Percentage Method table to use in Publication 15-T. If you’re using payroll software, plug the information from the employee’s Form W-4 into the system when setting up payroll.
You may have an employee who indicates they are exempt from federal withholding on Form W-4. If that’s the case, don’t withhold federal income tax from the exempt employee’s wages (except in the case of certain supplemental wages).
State income tax
State income tax can be either progressive or flat, depending on the state. Most states levy a state income tax on employee wages, but some states do not have income taxes.
For state income tax withholding, some states use the federal W-4 while others have their own state form. Your state tax withholding and form requirements will vary depending on the state.
If multiple states are involved for a single employee, things can get even more complicated. Depending on the situation, you may be required to withhold state income tax for both the state where the employee works and resides. Check with your state for more information.
Local income tax
Depending on your business location, you might need to withhold local income taxes from your employee wages. Local income tax withholding can be a little more convoluted than federal and state withholding.
Localities may assess a flat tax rate, progressive tax rate, or flat dollar amount. Income taxes imposed by cities and counties are based on where employees work and/or live and may have different rates for residents and non-residents. Some localities also impose a type of local tax called a school district income tax. School districts impose income taxes on residents only. Be sure to check with your locality for more information.
2. FICA Tax
FICA, or Federal Insurance Contributions Act, tax is made up of both Social Security and Medicare taxes. FICA is a true “payroll tax,” as both employers and employees contribute.
Social Security tax
The Social Security tax rate is a flat rate of 12.4%. Employers and employees split this 12.4% equally. Employers pay 6.2% per employee and withhold 6.2% from employee wages.
There is a Social Security wage base, which is subject to change annually. Employers and employees each pay the tax on wages up to the taxable maximum amount for the given year. Do not withhold or contribute for wages earned above the wage base.
Medicare tax
Medicare tax is a flat rate of 2.9%. Employers and employees split this 2.9% equally. Employers pay 1.45% per employee and withhold 1.45% from employee wages.
There is no Medicare wage base. However, there’s an additional Medicare tax that applies to employees who earn over $200,000. The additional Medicare tax is 0.9%, and only employees pay this.
3. Unemployment Tax
Like income tax, unemployment taxes aren’t technically “payroll taxes” because only employers pay them (with some minor exceptions—some states require employees pay the tax).
Federal unemployment tax
Federal unemployment, or FUTA, tax is a flat rate that only employers pay. The FUTA tax rate is 6% and only applies to the first $7,000 in wages paid to an employee during the year. This $7,000 is known as the FUTA wage base.
Although FUTA is a flat rate of 6%, there’s a twist: Most employers qualify for a FUTA tax credit up to 5.4%. This reduces the FUTA tax rate. Employers who qualify for the maximum FUTA tax credit of 5.4% only pay a net FUTA tax rate of 0.6% on each employee’s wages (6% – 5.4%). Employers in a credit reduction state are not eligible for the full FUTA tax credit.
State unemployment tax
State unemployment, or SUTA, tax is a flat rate that (for the most part) only employers pay. However, some states (Alaska, New Jersey, and Pennsylvania) require that employees also pay unemployment insurance contributions.
Unlike FUTA tax, the SUTA tax rate isn’t standard across all states. Each state has its own SUTA tax rate range, and your rate depends on factors like industry, the number of former employees who have received unemployment benefits, and your experience.
Like FUTA tax, SUTA typically also has a wage base (aka you stop paying it when the employee earns a certain amount). The SUTA wage base varies by state. Check with your state for more information on your rate and wage base.
4. Other Taxes
Keep in mind that your state might have additional payroll taxes. For example, Oregon has a statewide transit tax, as well as local transit taxes in some districts.
Several states also have paid family and medical leave programs funded through payroll taxes. Check with your state for more information.
How Much Are Employment Taxes? The Bottom Line
Skimmed to the end? I’m not offended—you’ve got more important things to do in your business. Here’s a quick summary of how each employment tax is calculated for payroll.
How is federal income tax calculated? Federal income tax is a progressive tax. Employers can use IRS Publication 15-T and Form W-4 to determine each employee’s income tax withholding.
How is state income tax calculated? State income tax can be a progressive or flat tax. Employers must consult their state’s withholding guide/resources for instructions and rates and use state W-4 forms where required to determine state income tax withholding.
How is local income tax calculated? Local income tax can be a progressive, flat, or dollar amount tax and may be imposed by cities, counties, and school districts.. Employers must consult their locality for more information.
How is Social Security tax calculated? Social Security tax is a flat rate of 12.4%, split equally between employees (6.2%) and employers (6.2%). Withhold and contribute the tax until the employee’s earnings reach the Social Security wage base.
How is Medicare tax calculated? Medicare tax is a flat rate of 2.9%, split equally between employees (1.45%) and employers (1.45%). If an employee earns above $200,000, withhold an additional Medicare tax of 0.9% from the employee’s wages only.
How is federal unemployment tax calculated? FUTA tax is a flat rate of 6% that employers pay on the first $7,000 of each employee’s wages. However, most employers qualify for a tax credit of 5.4% which reduces the net FUTA tax rate to 0.6%.
How is state unemployment tax calculated? SUTA tax is a flat rate employers pay that varies by state, along with factors like your industry, the number of former employees who have received unemployment benefits, and experience. Some states also require employees to pay SUTA tax.
Sure, You Can Calculate Payroll Manually … But Who Wants To?
If I could give my younger self any advice, it would be to streamline everything I could. It would have prevented a lot of headaches.
In fact, one of the big reasons I started my payroll company, Patriot Software, is because payroll is so confusing and time-consuming for business owners who try to do it manually.
Some business owners may think they’re saving money by handling payroll on their own, but here’s the catch: Time is money. And as a business owner, your time is priceless.
So do yourself a favor. Consider signing up for a payroll system to calculate, file, and deposit taxes. Trust me: You won’t go back to doing them manually again.
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