Calculating the various deductions, including federal income tax, is a challenging aspect of payroll management. Errors in income and payroll taxes are somewhat common, with about 1/4 of employees experiencing them. Mistakes can mean significant work for the payroll team and stress for the employee receiving the payment.
To many, the breakdown of deductions and withholding can be confusing, beginning with the differences surrounding payroll tax vs. income tax. Income tax is a levy by the government based on an employee’s wages. Payroll tax, however, is what the employer and the employee contribute to the Federal Insurance Contributions Act (FICA). These taxes fund Medicare and Social Security.
Although employees may use income and payroll tax interchangeably, those in payroll administration must understand the difference.
What is payroll tax?
Payroll taxes, also known as FICA taxes, are funds that support Social Security and Medicare. The tax, determined in part by the employee’s gross wages, is split between the employer and the employee. Employers base the FICA deduction on the employee’s adjusted gross pay and then match it for their contribution. Adjusted gross pay is the wage after pretax deductions, such as monies directed to a 401(k).
Social Security tax payment
On average, employees may pay 6.2% of their adjusted gross pay up to an annual limit for Social Security. The annual limit may change each year based on the average wage index.
Wage base limit
The wage base limit is the maximum wage amount subject to tax for a given year. It’s the point at which the employer can stop deducting Social Security tax. That number tends to rise incrementally each year. For example, in 2020, the wage base limit was $137,700. In 2021, it was $142,800.
The wage base limit only applies to Social Security tax deductions. There is no wage base limit for Medicare. If wages exceed a set annual amount, the employee must pay an additional .9% of their gross to support Medicare. The employer does not match that deduction.
The wage that triggers the additional tax is:
- $250,000 for married taxpayers who file together.
- $125,000 for married taxpayers who file separately.
- $200,000 for the single taxpayer.
This threshold may be subject to change, so employers should verify them at the start of each year.
Medicare tax payment
The payment for Medicare funding is 1.45% of the gross payroll. As with Social Security, employers will match the employee’s contribution.
All rates are subject to change and require verification.
What is income tax?
Payroll tax and income tax are similar but different. Income tax is a levy on businesses and individuals that funds programs at the federal and sometimes state and local levels. The deductions from an employee’s wages for personal income taxes depend on several factors. Those include the number of withholdings the employee claims on their W-4 form.
What is a W-4 form?
Payroll form W-4 is an Internal Revenue Service (IRS) document that new employees fill out to determine federal tax withholding. It informs employers how much of their adjusted gross pay to withhold for personal income taxes. Generally speaking, the more allowances they claim, the lower the employee’s income tax deduction. How much they pay through ongoing withholding will determine whether or not they receive a refund or owe money when they file tax returns for a given year.
Employees can fill out a new W-4 form if they want to increase or decrease their income tax deductions. Doing either will typically change the amount they owe at tax time. Employers should use the most recent W-4 form when calculating income tax deductions and will need to make an official payroll adjustment for changes.
Tax tables
Federal income tax withholdings are progressive, so they typically rise with higher salaries. The IRS issues its publication 15-T annually. This document provides tax tables that help employers determine income tax deductions.
The IRS bases its wage ranges on the tax tables on 3 factors:
- Pay frequency.
- Filing status.
- Withholding allowances.
Employers match the adjusted wages to the appropriate table and deduct the proper withholdings.
State income tax
For many employees, the need to pay income tax doesn’t end with federal income taxes. State and local income taxes may also apply. The methodology for calculating these differs based on location. For example, some states may follow the same progressive tax rate as the federal government. Others appoint a flat tax rate, which is the same tax rate for all, regardless of taxable income amount. And some states and locales don’t impose income tax at all.
Employers must know the laws in their city and state for payroll deductions.
Payroll tax vs. income tax: What’s the difference?
There are a number of apparent differences between these 2 payroll withholdings. They fund different programs. Income tax funds general government operations. Payroll FICA taxes are designated specifically for Social Security and Medicare.
Different methods for calculating each also apply. For the most part, FICA is a set percentage. Income tax on the federal level is progressive based on wages. That may differ on state and local levels.
Finally, FICA is a federal tax. Income taxes can exist at the federal, state, and local levels.
It’s important that employers understand the details surrounding both payroll and income taxes for tax compliance purposes. Errors in deductions can impact the employees’ cash flow and lead to penalties for the business.
Unemployment taxes
Unemployment tax is a payroll deduction applied in some states to fund unemployment insurance for covered workers. Typically only the employer pays into it, but some states require employees to contribute to state unemployment tax. Check the laws in your area to determine if this additional payroll deduction applies to you.
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