Understanding How Payroll Taxes Work

Arla Wallace is an accounting professional with over 20 years experience. She spent several years working for both publicly-traded and private entities before founding her own business. Today she partners with small business owners so they can focus on operations while leaving the responsibility of staying on top of accounting tasks to her. She is a Certified Public Accountant (CPA) and a Certified ProAdvisor for Quickbooks Online.

Understanding How Payroll Taxes Work

As a small business owner, hiring employees can be challenging—determining what you can afford, attracting the right candidates, and onboarding are just a few of the tasks you will encounter in the process. Another component of hiring is payroll tax. Calculated as a percentage of salary or wages paid to employees, the law requires employers to withhold payroll taxes from an employee’s paycheck and transmit these withholdings to the applicable tax agencies. And, unlike income tax (which creates a tax burden solely for the employee), payroll tax creates a tax burden for both the employee and the employer.

Federal Income Tax

Employees will need to complete Form W-4 for an employer to determine how much federal income tax to withhold. This form indicates the employee’s anticipated filing status and number of allowances. There are seven federal income individual tax rates for 2020. These rates range from 10 to 37 percent. Income tax is progressive meaning as taxable income increases, additional income is taxed at higher rates. Therefore, even taxpayers in the highest income tax bracket have some portion of income taxed at lower tax rates.

Social Security & Medicare Taxes

FICA stands for the Federal Insurance Contributions Act and represents both Social Security and Medicare taxes. The current FICA tax rate is 15.3% of employee wages. Not only does the employee fund FICA, but the employer matches the same amount that the employee will pay in FICA taxes. As such, the employee and employer both will pay 6.2% for Social Security along with 1.45% for Medicare. For tax year 2020, only the first $137,700 of earnings is subject to Social Security tax; this wage base increases to $142,800 for tax year 2021. Medicare tax, also known as the hospital insurance tax, currently has no wage limit but individual taxpayers who earn over $200,000 are subject to an additional 0.09% tax on Medicare. There is no employer match for the additional Medicare amount above $200,000.

FUTA Tax

For small businesses that have at least one employee that works at least 20 weeks out of the year or is paid at least $1,500 in any quarter, FUTA taxes must be paid. FUTA stands for the Federal Unemployment Tax Act, which is a government program that provides relief to eligible employees following termination due to no fault of their own. FUTA tax is 6% on the first $7,000 of employee wages and is paid solely from the employer’s funds. For self-employed business owners, you pay this tax. Employers can earn a federal tax credit provided employee wages are subject to a state unemployment tax.

State & Local Taxes

Small business structure and location dictate whether hiring an employee will trigger state and local income taxes. Because tax laws differ by location, check with the state and local government agencies to know tax obligations specific to your small business. State payroll taxes are generally paid monthly or quarterly depending on how big your payroll is; the state and local government agencies can provide the correct timetable.

State Unemployment Insurance

The State Unemployment Tax Act, or SUTA, is a required employer payroll tax on employee wages paid to the state unemployment fund. Contributions into state unemployment funds provide support for displaced workers. Some states require both the employee and the employer pay SUTA taxes. Because rates vary from state to state and can change annually, it is important to check with your state government agencies to determine the tax obligations specific to your small business.

Paying Taxes

You must deposit the taxes your small business withholds from employee paychecks. Pay taxes and file returns on time to avoid penalties. The Electronic Federal Tax Payment System (EFTPS) is free and allows employers to make federal tax payments either by telephone or online. Outsourced payroll providers submit federal tax deposits electronically. When you register as an employer in a given state, you will learn how to pay and report taxes withheld for the state and local government levels.