- Payroll taxes, or withholding taxes, are withheld from an employee's paycheck and paid to the IRS.
- The employee contribution rate is 7.65%, which goes toward Social Security and Medicare.
- Employers must withhold federal income tax in addition to any state or local taxes.
- This article is for small business owners looking for more details on payroll taxes and how they apply to them.
If you're a small business owner in the United States, you'll need to understand payroll taxes from the moment you hire your first employee. Dating back to Franklin D. Roosevelt's New Deal, payroll taxes are the taxes withheld from an employee's earnings (including any wages, salaries, bonuses or cash gifts from the employer) to fund federal programs like Medicare and Social Security.
Instead of directly taxing employees, who may or may not pay their taxes on time, the government requires employers to withhold a percentage of employee paychecks. As a result, it's up to small business owners to understand the ins and outs of taxes. Employers can handle this process on their own, enlist the help of a tax professional, or employ a payroll service to handle all of their payroll and payroll tax responsibilities.
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What are payroll taxes?
Payroll taxes have two main components. The first part is the portion of an employee's paycheck the employer withholds. This is called the employee contribution and is shown on their pay stub. The second part is the amount employers contribute, which is also based on employee pay.
- Social Security: Both employers and employees pay Social Security taxes and contribute the same 6.2% of the employee's wages.
- Medicare: Like Social Security taxes, both the employer and employee pay Medicare taxes – 1.45% each of the employee's wages, for a total of 2.9%.
- Federal Unemployment Tax Act (FUTA): This is an employer-only tax; FUTA is not withheld from employee wages like Social Security and Medicare taxes.
- State Unemployment Tax Act (SUTA): Like the FUTA tax, the SUTA tax is employer-only in most states. However, in Alaska, New Jersey and Pennsylvania, employees are required to contribute to SUTA taxes.
- As can be expected, state income taxes vary widely. As of 2021, 41 states have some form of income tax. Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming do not have a state income tax. However, some localities, cities, counties or districts do have income taxes. Contact your local government to determine whether your business is expected to pay certain local income taxes.
How do payroll taxes work?
Payroll taxes are withheld from each employees' paycheck to fund Social Security and Medicare. Employers are responsible for withholding their employees' taxes and submitting them, along with their employer share of Federal Insurance Contributions Act (FICA) taxes, to the IRS.
When employees file their taxes, they do not have to manually input their payroll tax from each paycheck, as their employer will do it for them. After employees file their taxes, they may get a tax return from the IRS. This occurs when an employer overestimates how much an employee owes and takes that amount out of their paycheck. The government returns the overpayment to the employee.
Did you know? If you're married and filing your taxes jointly, you may not have enough Medicare taxes withheld. If your earned income is over $250,000, you'll be subject to an additional tax. This also applies to married people filing separately if their income is over $125,000, and it can be covered by adjusting your withholdings and making estimated tax payments.
What do payroll taxes include?
Payroll taxes are divided into three main streams: Social Security and Medicare, which are mandated under FICA, and federal income.
Social Security contributions are paid into a fund toward senior benefits and disability insurance, while Medicare provides healthcare for the elderly. In addition to withholding taxes from an employee's paycheck, employers must match Social Security and Medicare contributions and issue other payments like state and federal unemployment taxes or workers' compensation.
Sonya Muenchen, founder of The Payroll Gal, has been a payroll tax consultant for small businesses for more than 20 years. She said it's important for business owners to understand exactly what they're responsible for.
"As an employer, you are responsible for … keeping track of time, calculating payroll based on employees' tax certificates, and depositing a payroll check on a weekly, biweekly, semimonthly or monthly basis," she said.
According to the Society for Human Resource Management, the taxable wage cap for Social Security is typically raised each year based on increases in the national average wage. In 2021, the maximum earnings subject to the Social Security payroll tax is increasing by $5,100, to a total of $142,800.
Payroll taxes and income tax
In addition to Social Security and Medicare contributions, which are paid into specific funds, employees must pay a federal income tax. An employee's tax rate is determined by their federal income tax bracket, which is adjusted for inflation each year by the IRS. Unlike the FICA tax, federal income tax is not paid into any specific fund.
Depending on your location, you may have additional withholding and income taxes.
"States and some localities also have payroll taxes and often include such things as state disability insurance," said Michael Law, a certified public accountant with Canopy Tax. "If any of your employees earn over $200,000, there is an additional Medicare surtax withholding on them."
Wage limits and payroll taxes
For 2021, the wage base limit is $142,800. If an employee earns that amount with one employer, then their payroll taxes are capped at that wage. If someone has more than one employer and earns more than that amount, they'll have to make a claim adjusting any overpaid Social Security taxes.
The Medicare tax has no wage-based limit, as all covered wages are subject to it. However, if you make over $200,000 a year, your employer will withhold an additional 0.9% Medicare tax.
Key takeaway: Payroll taxes include payments for Social Security and Medicare. There are also federal income taxes that must be paid. These payments do not go into a specific fund like the Social Security and Medicare taxes do.
What is the payroll tax rate?
Employer tax obligations
Employers are responsible for the following taxes on their employees:
- Social Security: 2% (for a maximum salary of $142,800 in 2021)
- Medicare: 45% (plus 0.9% for salaries exceeding $200,000)
- Federal unemployment tax: Varies by state
- State unemployment tax: Varies by state
Employee tax obligations
The employee contribution for payroll taxes is calculated as a percentage of taxable wages. For some employees, taxable pay will be lower than gross pay – for example, if they contribute to a 401(k). Net pay refers to take-home pay, or gross pay minus tax.
As of 2021, the payroll tax rate withheld from employees is 7.65%, plus federal and state income tax. This is how it breaks down:
- Social Security: 2% (for a maximum salary of $142,800)
- Medicare: 45% (plus 0.9% for salaries exceeding $200,000)
- Federal income tax: Varies by tax bracket
- State income tax: Varies by state
If you're your own boss, you'll have to withhold your own taxes. The self-employed payroll tax rate is 15.3%. [Read related article: Freelance Taxes: What Every Freelancer Needs to Know]
Key takeaway: Employers and employees each have their own payroll tax obligations Employers pay payroll taxes for Social Security, Medicare, federal unemployment and state unemployment. Employees pay for Social Security and Medicare based on a percentage of their wages.
Paying payroll taxes
Law said how often you make payroll tax payments typically depends on the size of your business, how often you run payroll and the type of employer you are.
"Household employers with small payrolls have the most lenient deposit requirements, with annual deposits," he said. "Those with larger payrolls need to make deposits either monthly or semiweekly."
Law said businesses that are unlucky enough to be caught in a federally declared disaster area may have their required payments relaxed for a short time.
While it's possible to complete payroll taxes on your own, it can be complicated, especially when it comes to keeping track of payments and withholding the right amount of money.
"The most solid yet basic advice I give business owners is to get a payroll company and get in the habit of depositing everything they tell you to deposit," said Anthony Parent, owner of tax law and business tax services firm Parent & Parent LLP.
Key takeaway: How often you pay your payroll taxes is generally determined by the size of your business, the type of business you run and how often you process payroll.
Managing payroll taxes
There are several ways you can manage employee payroll taxes and ensure that your business is compliant with the IRS:
- Do them yourself. Complete the payroll taxes for each employee in your company. This involves analyzing each employee's W-4 tax form, calculating allowances, referring to income tables and doing basic arithmetic to withhold the right amount of money. Keep in mind that you'll have to calculate for state and federal payroll tax withholdings.
- Use a payroll service. Payroll services are third-party payroll processing companies that manage employee payroll. These services come fully baked with tax compliance, payroll processing and various other features. They make money off a monthly fee or on the interest of the money they collect for payroll taxes. Payroll service pricing typically includes both a flat monthly fee and a per-employee fee. The base monthly costs generally range from $20 to $100 per month, with the per-employee fees ranging from $1 to $15. Consider our review of Paychex, one of our best picks for payroll services.
- Work with a tax professional. Besides working with a payroll service, you can work with a tax professional. You can also talk with an accountant about completing payroll taxes, although they may refer you to a payroll service.
If you invest in a service or work with a tax professional, rather than taking care of payroll taxes yourself, you can spend more time handling important projects and issues within your business.
Tip: For employers, the Coronavirus Aid, Relief, and Economic Security (CARES) Act is a tax law that gives U.S. small businesses coronavirus relief. Multiple tax credits within the law benefit small businesses, including one for payroll tax postponement. Contact your accountant or financial advisor for more information on how to utilize these provisions.
What happens if you don't pay your payroll taxes?
Making sure payroll taxes are paid to the right agencies and on time isn't a task you should take lightly. If you don't make your payments on time, you could face huge fines, see your business shut down and possibly spend time behind bars.
Law said any money that you withhold from your employees' paychecks for payroll taxes technically belongs to the government.
"You have a fiduciary duty to turn over those funds to the applicable government agency," he said. "You are not compensated for the fiduciary relationship, but you are penalized if you fail to pay over the amount due at 100% of the amount that should have been paid."
If you don't pay the correct payroll taxes or you send in payments later than they are scheduled, the IRS may pay you a visit.
"Should you get behind in paying the payroll taxes, you will get IRS notices and eventually a personal visit from the IRS," Law said. "Continual failure to pay the payroll taxes will result in the IRS shutting down your business and possible jail time."
Parent said the IRS can get aggressive over missed payroll taxes. The structure of payroll taxes means that when a company doesn't withhold the right amount of money, the government can miss out on a lot of funding. That means IRS officials will be up to date on whether you're paying your share of taxes.
"A revenue officer will likely get assigned and make an up-close and personal inspection of your affairs," Parent said. "Many people, including myself, think that skipping payroll deposits to make ends meet is truly a deal with the devil."
Payroll taxes are an important part of your business. While it may be easy to focus on your day-to-day operations and forget about high-level organizational aspects, payroll taxes are something your business must contribute. Consider either partnering with a payroll service or working with a tax professional to protect your business from the IRS.
Key takeaway: Failing to pay your payroll taxes correctly and on time can result in significant fines from the IRS. You may also see jail time or be forced out of business.
Siri Hedreen contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.