If only paying your employees was as easy as sending them their salary. But as with anything involving the Internal Revenue Service (IRS), it’s not so simple. First, you have to pay taxes on the employees' wages. And second, during each pay period, you have to withhold a certain portion of each employee’s salary for tax purposes.
Mandatory withholdings include payroll tax and income tax. These two types of taxes may sound like you can use them interchangeably, but they’re not the same.
Keep reading to learn the difference between payroll tax vs. income tax and how to calculate each for your employees.
What Is the Actual Difference Between Payroll and Income Taxes?
Payroll tax and income tax are both employment taxes, which are withheld from employee pay stubs. The difference is in who pays them. Employers are responsible for paying half of the payroll tax, also known as FICA tax, which funds Social Security and Medicare. Employees pay the other half.
Meanwhile, employers don’t pay income taxes on behalf of their employees. Employees are fully responsible for paying their own income taxes, which are taken out of their paychecks. These taxes fund a variety of things, including state and local programs.
This may be a great base knowledge on the subject, but what exactly are each of these taxes and how do you calculate them? We’ll go into all that and more in the next few sections.
What Are Payroll Taxes?
A payroll tax is any portion of an employee’s wages withheld to fund federal programs. In the United States, the payroll tax was created by the Federal Insurance Contributions Act (FICA), which uses the tax to fund Medicare and Social Security. For this reason, the U.S. payroll tax is also known as the FICA tax.
Payroll tax is an example of an employment tax, which is a broader category that encompasses other taxes (not just FICA). Other employment taxes include Federal Unemployment Tax (FUTA) and State Unemployment Insurance (SUI) taxes, which fund state unemployment benefits.
Who Pays the Payroll Tax?
Employers and employees split the burden for FICA taxes. In other words, you each pay half of the tax.
How To Calculate Payroll Taxes
Payroll tax includes two taxes: Social Security and Medicare. In most cases, FICA taxes are a flat rate of 15.3% total split evenly between employer and employee. So you each pay 7.65%. But you may need to make adjustments for any employee that makes more than $147,000 per year.
Here’s how the payroll tax rates break down for each category:
- Social Security: 6.2% for the employer and the employee, which applies to the first $147,000 in wages.
- Medicare: 1.45% for the employer and the employee. Employers must withhold an additional 0.9% once an employee’s cumulative wages go over $200,000 in one year.
So what’s with those wage thresholds on each tax?
Essentially, the Social Security tax only applies to each employee's first $147,000 wages. Once their wages are higher than $147,000, the Social Security tax doesn’t apply for the rest of the year.
On the other hand, Medicare taxes have a threshold of $200,000 for the 1.45% rate. Once an employee’s pay gets higher than $200,000, you’ll have to withhold an extra 0.9% for Medicare. The employee’s tax rate becomes 2.35% on wages over $200,000. Employers don’t have to match the additional Medicare tax, so your rate stays flat at 1.45%.
Let’s take a look at two examples based on employees Jim and Angela.
Say Jim earns $60,000 per year, paid out twice each month. Here’s how FICA tax withholding will look on his paystub.
Gross wages: $2,500
Social Security tax withheld: $155 (6.2% of $2,500)
Medicare tax withheld: $36.25 (1.45% of $2,500)
Total federal payroll taxes withheld: $191.25 (Employer will also pay $191.25)
Net wages after FICA taxes: $2,308.75
Since Jim’s cumulative wages don’t reach the $147,000 limit for Social Security or the $200,000 threshold for Medicare, his FICA withholdings will stay the same throughout the year.
On the other hand, Angela earns $240,000 per year, paid out twice each month. At the beginning of the year, you’ll withhold taxes at the same rate for Angela as you did for Jim:
Gross wages: $10,000
Social Security tax withheld: $620 (6.2% of $10,000)
Medicare tax withheld: $145 (1.45% of $10,000)
Total federal payroll taxes withheld: $765 (Employer will also pay $765)
Net wages after FICA taxes: $9,235
But after seven months, Angela’s total salary will be more than $147,000, which is the limit for Social Security taxes. So you no longer withhold the $620 of her Social Security. You only withhold $145 for Medicare.
After 10 months, all the wages paid to Angela will pass the Medicare threshold of $200,000. At that point, you would need to apply the extra 0.9% Medicare rate increase, which brings her withholdings to 2.35% of gross wages or $235. The rate increase doesn't apply to the employer’s portion of the tax, so you’ll still only pay $145.
Payroll software like Hourly automatically deducts the right amount of FICA tax from each employee’s earnings, so you don’t have to worry about remembering all the wage limits and thresholds. What’s more, Hourly submits all your payroll taxes for you. Now that’s pretty dang nice, isn’t it?
Self-employed individuals, such as freelancers and independent contractors, pay both the employer and employee portion of payroll taxes. Since they’re not on a payroll, this tax is called the self-employment tax (SE tax).
What Are Income Taxes?
Income taxes are paid on money earned from various sources, including wages, capital gains, and rent payments. Unlike FICA taxes, which go to Social Security and Medicare, income taxes can go to several different places. Most states impose their own income tax, and even some localities (such as towns and cities) have separate income taxes.
As an employer, you don’t have to pay any portion of your employees' income taxes, but you usually have to deduct them from employee paychecks.
Payroll tax and income tax are separate deductions. Payroll tax is not included in income tax. However, both are considered employment taxes because they are withheld from employee paychecks.
How To Calculate Income Taxes
The U.S. uses a progressive tax system for its income tax rate, which means the more you make, the more you’re taxed. So once your income gets into a higher tax bracket, the money that specifically falls into that bracket gets taxed at a higher rate.
For example, the first tax bracket for single filers is $0 to $9,950 of taxable income, which is taxed at 10%. The next bracket is $9,951 to $40,525 of taxable income, which is taxed at 12%.
So, if an individual has a taxable income of $40,000 for the year and their filing status is single, their income taxes would be:
- 10% of the first $9,950 = $950
- 12% of the remaining $30,050 = $3,606
- Total income tax = $4,556
Instead of paying 12% on their whole income, the individual pays 10% on the first bracket and 12% on the amount of income that qualifies in the second bracket.
Methods for Withholding Income Tax
You can use two methods to calculate the taxes withheld from each employee’s paycheck: wage bracket and percentage.
You can find instructions for both methods using IRS Publication 15-T, Federal Income Tax Withholding Methods. Both methods use information from your employee’s pay stub and their W-4 Form or Employee’s Withholding Certificate.
You should have employees fill out IRS Form W-4 during their onboarding process and before you send their first paycheck since it tells you how much income taxes to deduct from their pay.
We recommend the wage bracket method since it requires fewer calculations. However, if you have an employee that earns a higher salary or has more than 10 allowances on their W-4 form, you might have to use the percentage method.
Either method you choose, manually calculating income tax withholdings for each employee is tedious work. Instead, you can use payroll software like Hourly that automatically organizes W-4 forms and calculates and submits income tax deductions for each pay stub.
You’ll also need to follow any state and local income tax instructions that apply to you, so check those local departments of revenue for that info. California, for instance, requires that employees also submit Form DE 4 for state income tax withholding. Or, let Hourly do all that for you (which it does!).
Income Taxes for Self-Employed Individuals
People who work as freelancers or independent contractors don’t receive employee pay stubs where FICA and income taxes are automatically withheld. Instead, self-employed people must pay estimated income taxes throughout the year and report their estimated payments when filing their tax returns.
Each quarter, they estimate their self-employment and income tax and use them to make payments to the IRS. If you’re self-employed, you can reference the Self-Employed Individuals Tax Center on the IRS website or work with a Certified Professional Accountant (CPA) for help with making estimated tax payments.
Final Thoughts: Payroll Tax vs. Income Tax
Payroll tax and income tax are both examples of employment tax since you withhold them from employee paychecks. The payroll tax is levied by the federal government. It funds Social Security and Medicare programs, and it’s split between employee and employer. On the other hand, income tax is paid solely by the employee, but it’s still the employer’s job to withhold the amount on paychecks. Income tax funds all sorts of programs, including state and local ones.
Calculating tax withholdings can be challenging, especially for small business owners with several employees. The good news is that you can make paycheck withholdings easier by using a payroll software solution like Hourly that automatically calculates and withholds taxes like payroll and income.