At a glance:
What are payroll taxes?
Federal and state taxes
Social Security and Medicare taxes
Reporting and depositing payroll taxes
Summary of payroll taxes
If you are like many young Americans, when you got your very first paycheck at the burger joint, department store, or wherever else you worked, you probably suffered a bit of tax shock as you saw a chunk of your hard-earned money taken back by your employer.
It's as though you were working for the IRS for an entire day or two each week. Indeed, if you were to satisfy your tax obligations first, starting on January 1, they wouldn't end until April if you were the average American.
Ever wonder what all those taxes out of your paycheck are for? You should. The government takes a certain percentage of your wages to fund various programs that Americans can take advantage of.
In many — but not all — states, unemployment and income taxes fund payments of unemployment insurance and many state initiatives. Locally, local income taxes support the cities and counties you live and work in.
These taxes are paid on a certain percentage of your income and are automatically taken out of your paycheck by your employer. While you do have some say in how much income tax is taken out of your check, you have no say in how much Medicare, Social Security and unemployment taxes are withheld.
Let's take a look at payroll taxes in more depth.
What are payroll taxes? Here are the basics
Payroll taxes include federal, state, and local income taxes, federal and state unemployment taxes, and Medicare and Social Security taxes.
They are automatically taken out of your paycheck every time you are paid, based on a flat, fixed tax rate for state and local income taxes and Medicare and Social Security taxes.
For federal income taxes, the rate depends on your tax filing status and the number of withholding allowances you designate when you fill out federal tax withholding forms.
What are they used for?
Some taxes are used to fund a broad array of programs. Federal, state, and local taxes fund government programs such as road construction, emergency disaster relief, enforcement of safety, and environmental regulations and health care. Other taxes are specifically designated to fund certain programs.
This applies to the Social Security and Medicare taxes, which fund Social Security benefits and Medicare health care programs for the elderly.
Who pays them?
Both employers and employees pay payroll taxes. Employers pay the taxes that fund unemployment insurance payments on both the federal and state levels.
These programs are known as FUTA (Federal Unemployment Tax Act) and SUTA (State Unemployment Tax Act) for the legislation that authorizes the collection of unemployment taxes. Employees do not contribute to FUTA and SUTA.
Both employees and employers pay Social Security and Medicare taxes, with each paying half the tax due. Employees pay federal, state, and local income taxes; employers do not pay personal income tax, but do pay corporate income tax. The FUTA tax rate is 6.2%, but employers can receive a credit of up to 5.4% for SUTA taxes paid.
Federal and state taxes
Federal tax rates vary depending on your filing status. The most favorable tax status is married filing jointly or qualifying widow or widower, followed by head of household (a separated, divorced, or single person who resides with one or more dependents), single, and then married filing separately.
Married persons can either file jointly or separately. Taxpayers can claim head of household status if they have one or more qualified dependents living with them during the tax year.
Dependents can include minor children, dependent elderly or disabled relatives, or other relatives or non-relatives who meet IRS dependency tests. Qualifying widows and widowers can claim married filing jointly status in the two years following the death of their spouse, provided they are unmarried during the tax year and have a child, adopted child, or stepchild they can claim as a dependent.
Single status applies to taxpayers who are unmarried and have no dependents.
Married filing jointly
Generally, married filing jointly tends to be the most favorable filing status, though in certain cases married persons pay higher taxes than single persons with the same income and deductions. Head of household is in most cases the second most favorable filing status, followed by single and then by married filing separately. For each filing status, there are these brackets: 10, 12, 22, 24, 32, 35, and 37%.
Under certain circumstances, the alternative minimum tax could result in a higher effective tax bracket, but this tax is not generally considered in filling out a W-4 form but is a separate calculation you might have to make on your yearly federal income tax form.
Getting started with the W-4
When you begin employment and at certain times thereafter, you fill out a federal Form W-4 withholding form, which is provided by your employer. Prior to the new tax law in 2018, you would also state the number of withholding allowances you wished to claim; these were the personal exemptions you took, and they reduced your taxable income.
The new tax law eliminates exemptions, though it also raises the standard deduction. Your employer uses your W-4 form to determine what percentage of federal and state income taxes to withhold from your paycheck.
How employers withhold
When determining payroll tax rates for federal income taxes, employers use tax tables provided by the Internal Revenue Service, found in Publication 15, Employer's Tax Guide.
Based on the employee's filing status, how often the employer pays employees — weekly, biweekly, semimonthly, monthly, quarterly, semiannual or annual — their income and number of withholding allowances, the employer withholds a certain amount of money per pay period to pay the employees.
How state taxes work
States that levy an income tax may set a flat rate or rates based on the amount of income you earn, as do local governments that levy an income tax. For both local and state income taxes, you generally pay tax on your compensation income based on the state and locality where you work, rather than where you live.
To avoid double taxation, you are generally given a credit for the state and/or local government where you paid the tax so you do not have to pay extra taxes where you live in addition to those you paid in the locality and state where you work.
Social Security and Medicare Taxes
Social Security and Medicare taxes — also known as FICA taxes — have been 6.2% each for employers and employees for Social Security, and 1.45% each for Medicare. Both the employer and employee pay Social Security taxes on the employee's wages up to $137,700 in 2020. (There is no limit to the amount of wages to which the Medicare tax applies.)
Once that limit is reached, no more taxes are withheld for Social Security for the rest of the calendar year; an additional 0.9% tax is withheld on earned income above certain thresholds (but not matched by employers). Withholding of FICA taxes is resumed at the beginning of the new calendar year.
The FICA withholding limit is indexed for inflation, so it increases each year based on the general level that prices have increased in the economy during the past year, known as the inflation rate.
What is Social Security?
Social Security is a federally sponsored retirement income and disability income program. Based on how much a person has earned during their lifetime, they receive benefits once they retire.
The earliest permissible age to receive Social Security benefits is currently 62. If beneficiaries wait until age 65, 66 or 67 to receive benefits, their monthly benefit is larger than if they started taking benefits at age 62.
The benefits received do not equal what a beneficiary contributed into the system, as retired workers generally end up getting more in benefits than they contributed.
Medicare taxes pay for the Medicare health care program, which provides health care coverage for all US citizens over the age of 65. Coverage includes hospitalization, care by physicians, and some drug and medical equipment benefits.
Reporting and depositing payroll taxes
Employers can either directly report and deposit payroll taxes with federal, state, and local governments, or they can contract with a payroll company to handle this task.
Generally, filings are handled electronically. The employer designates how much of each tax is to be withheld each pay period by each employee, and those funds are withheld from paychecks and electronically deposited on a periodic basis with the relevant federal, state, and local agencies.
Sending in payments
Companies can mail in payment or use the Electronic Federal Tax Payment System to deposit payments at any financial institution that is an authorized depository for federal taxes.
There are two schedules for depositing Social Security, Medicare, and federal income taxes. Which schedule an employer must follow depends on how much in total tax withholdings they deposit in a year's time.
Employers with a larger withholding — more than $50,000 per year — must deposit withholdings on a semi-weekly basis, while those with less deposit on a monthly basis. Employers who fail to file or deposit less than their tax liability are subject to interest and penalties.
What happens if too little is withheld from your paycheck?
If you or your employer fails to have sufficient funds withheld from your paycheck, the IRS could hold you personally liable for the shortfall.
Generally, there are penalties and interest for failing to have enough funds withheld from your check to either meet your tax liability or to pay enough to cover your previous year's tax liability.
You must also pay taxes on any bonuses, non-cash gifts, and benefits such as life insurance that are subject to federal tax.
Summary of payroll taxes
You should now have a better sense of what you're getting for all those hours you put into your taxes. Like death, payroll taxes are a fact of life for employees and employers.
Employees must pay a variety of taxes that are deducted from their paychecks, which include federal, state, and local income taxes and Medicare and Social Security taxes. Employers must match employee payments for Medicare and Social Security and also pay federal and state unemployment taxes.
Your federal, state, and local payroll tax liability depends on several factors, including your filing status and your tax rate.
Medicare and Social Security tax rates are fixed and help support these programs that provide income and health care coverage for retired people. Employers are responsible for deducting and depositing payroll taxes on a timely basis to the relevant taxing authority.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
Read more information and tips in our Taxes section