If you’re running a business, you need be an expert on a lot of topics. You need to be an expert seller, an expert marketer, expert coach…and so on. What you don’t really want to be is an expert on payroll taxes. That’s why we highly recommend working with an HR provider who can take this burden off your plate (here’s exactly what we mean by “burden”). Taxes in general can be confusing, and business tax even more so. Here’s a quick refresher on one of the basics: businesses are responsible for withholding both payroll and income taxes. There are no excuses for mixing up these up, so here’s a mini refresher course.
Payroll Taxes vs Income Taxes: An Introduction
Payroll taxes are paid for by both an employer and an employee, and go toward Social Security and Medicare. In 2021, both employer and employee pay 7.65% on the first $142,800 and then 1.45% on earnings above that figure. There is a further, additional Medicare tax of 0.9% for those earning $200,000 and above.
Income taxes are paid by employees only, operate at a federal, state or local level, and fund government spending and public services. Federal income taxes—calculated using an employee’s W-4 form—are progressive, dependent on their household and marital circumstances, and employees will only pay if they earn over a certain threshold.
What’s the Difference Between Payroll and Income Taxes?
The key difference is that payroll taxes are paid by employer and employee; income taxes are only paid by employers. However, both payroll and income taxes are required to be withheld by employers when they make payroll.
The taxes also affect employees differently. For most households it’s payroll taxes not income taxes that hit harder. That’s because income taxes are progressive, so those who earn more, pay more. Payroll taxes are regressive, since the more you earn, the lower the percentage of your salary that will end up as payroll tax.
This also means that payroll tax is relatively simple. Income taxes however, with flexible rates decided based on multiple factors, are more complex, and make up the bulk of tax return calculations. The taxes also have different purposes—federal payroll taxes fund specific programs, while income taxes can be used for any purpose decided by local, state or federal government.
How Payroll Tax is Calculated
Now, let’s go a bit deeper into how payroll and income taxes actually work. Federal payroll tax is also known as FICA tax, mandated by the Federal Insurance Contributions Act. Most of this goes toward social security—both employers and employees pay 6.2% until a limit of $142,800 (in 2021). That makes a maximum of contribution of $8,853.60 each. These limits are adjusted annually for inflation.
Employers and employees contribute a further 1.45% to Medicare, with no limit. Employees who earn over $200,000 are taxed a further 0.9%. Note that this additional tax does not apply to employers.
For more information, read our in-depth guide on how to pay payroll tax.
How Income Tax is Calculated
Income taxes are only paid by employees, and are imposed at a local, state or federal level. These taxes fund government spending. All but nine states tax employee incomes—the exceptions are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. In addition, many cities and counties across the country impose further, local income taxes.
Employers can calculate the amount of federal income tax to withhold based on an employee’s W-4 form filing. To assist calculations, employers can refer to IRS Publication 15 – Circular E. Paying state or local income taxes will also require employees to submit a withholding form.
Employees are responsible for paying income taxes on sources of income outside their primary employment, like bank interest, dividends, or profit from the sale of stocks or property.
Calculating taxes correctly is essential—but if you try to do this alone, you risk making costly errors. The good news is, Paycor can help. Our Human Capital Management platform gives HR leaders the technology and expertise they need to save time, stay compliant and start making a difference. To learn more, talk to a member of our sales team.