Payroll Tax vs. Income Tax: Key Distinctions & What to Know

Taxes are an inevitable financial component of earning an income. Two primary types of taxes that individuals and businesses encounter are payroll tax and income tax.

Navigating complex tax regulations requires understanding the difference of payroll tax vs. income tax for accurate financial management and compliance. This article breaks down their key distinctions, explaining how these are calculated and discussing the payroll and income tax rates that will provide insights into your overall tax burden.

We'll also introduce Paystubsnow, an efficient tool for generating compliant paystubs that automatically account for both payroll and income taxes, and discuss how it can make tax season a breeze.

Main Takeaways From This Article:

• Payroll taxes fund specific government programs like Social Security and Medicare, while income taxes contribute to the general government budget.
• Both employees and employers share responsibility for payroll taxes, while income taxes are primarily the employee's burden.
• Payroll taxes have a flat or capped rate, whereas income taxes are progressive, meaning higher earners pay a higher percentage.
• Paystubsnow simplifies tax reporting by generating compliant paystubs that accurately reflect all tax deductions.

What Is Payroll Tax?

Payroll taxes, also known as employment taxes, are a portion of a paycheck withheld to fund government programs like Social Security and Medicare. Social Security benefits retired workers, their dependents, and survivors, while Medicare provides health insurance coverage for seniors over the age of 65. These mandatory contributions are levied on both employers and employees and are automatically deducted by your employer before you receive your net pay.

How to Calculate Payroll Taxes

Payroll taxes are calculated as a percentage of an employee's gross wages. The two main payroll taxes are Social Security and Medicare taxes.

• Social Security Tax: The Social Security tax is a 6.2% tax applied to both employees and employers on wages up to a maximum taxable amount (the Social Security wage base), which is adjusted annually.
• Medicare Tax: The Medicare tax is a 1.45% tax applied to all wages by both employees and employers. There is no maximum taxable amount for Medicare tax.

Let's say an employee earns a gross bi-weekly salary of $5,000. To calculate their Social Security tax contribution, you would multiply their gross wages by the Social Security tax rate (6.2%):

$5,000 gross wages x 6.2% Social Security tax = $310 Social Security tax

Since there is no maximum taxable amount for Medicare tax, the calculation for Medicare tax is straightforward:

$5,000 gross wages x 1.45% Medicare tax = $72.50 Medicare tax

In this example, the total payroll tax contribution for this employee would be $310 + $72.50 = $382.50 per pay period. The employer would also be responsible for contributing the same amount of payroll taxes ($382.50) for a total of $765 in payroll taxes for the employee.

What Is Federal Income Tax?

Federal income tax, also known as personal income tax, is imposed on an individual's taxable income, which is gross income minus allowable deductions. The system is progressive, with higher earners paying a larger percentage in taxes. There are seven tax brackets, each with varying rates. The amount withheld from paychecks is influenced by factors such as filing status, number of dependents, and W-4 withholding choices and goes toward funding various government operations and programs.

How to Calculate Income Taxes

The process of calculating federal income tax liability can be somewhat complex as it considers various factors like an employee's filing status, taxable income, and deductions. However, you can calculate federal income tax withholding for each employee by using the IRS Tax Withholding Estimator tool.

This tool will take into account the filing status, dependents, and expected income of each employee to provide you with an estimate of how much federal income tax should be withheld from their paycheck each pay period.

Payroll Tax vs. Income Tax: Key Differences

While both payroll taxes and income taxes are deducted from your paycheck, there are some key differences between the two, including:

Purpose and Allocation

Payroll taxes are specifically allocated to fund Social Security and Medicare programs, which provide benefits to retirees, disabled individuals, and families of deceased workers.

Income taxes are a broader source of revenue for the government. These taxes are collected from individuals and businesses and are used to fund a wide variety of public services, including education, infrastructure projects, and national defense.

Responsible Party

Both employers and employees are responsible for payroll taxes. Employers withhold the employee's share of Social Security and Medicare taxes from their paycheck and then match that amount with their own contribution.

Employers are responsible for withholding federal and state income taxes from an employee's paycheck. The employer may withhold a portion of an employee's wages to prepay their estimated tax liability, but the taxpayer is ultimately responsible for paying the taxes in full.

Calculation Methods

Payroll taxes are calculated using a flat tax rate applied to an employee's gross wages. This means that a specific percentage of the employee's earnings is deducted for Social Security and Medicare taxes. For example, Social Security tax is currently 6.2% of wages up to a certain limit, and Medicare tax is 1.45% of all wages.

Income taxes, on the other hand, are calculated using a progressive tax system, where the tax rate increases as income increases. This means that higher-income individuals pay a higher percentage of their income in taxes.

Withholding Processes

Payroll taxes are typically withheld directly from an employee's paycheck on a regular basis, such as weekly, bi-weekly, or monthly. This ensures that the taxes are collected throughout the year.

Income taxes are often withheld based on the employee's W-4 form, which indicates their desired tax withholding rate. Employers then withhold a portion of the employee's wages each pay period and remit those taxes to the IRS.

Employee Tax Responsibilities

Each employee plays a crucial role in fulfilling their tax obligations. Here are some key employee tax responsibilities:

1. Social Security Tax

As an employee, you contribute to the Social Security program by paying a portion of your earnings. This tax helps support retirement benefits, disability benefits, and survivor benefits. The current Social Security tax rate is 6.2% of wages up to a specific annual limit.

2. Medicare Tax

You also contribute to the Medicare program, which provides health insurance coverage for eligible individuals. The standard Medicare tax rate is 1.45% of all your earnings, regardless of your income level. This amount is usually withheld from the employee's paycheck.

3. Federal Income Tax

The federal government levies income tax on your taxable income. The amount withheld from an employee's paycheck depends on factors such as your income level, filing status, and the number of allowances you claim on their W-4 form.

They will need to file a federal tax return annually to determine their final tax liability and potentially receive a refund or pay additional taxes.

4. State Income Tax

Many states impose their own income tax. Employees working in these states that levy state income tax are generally responsible for paying this tax. The employers will typically withhold a portion of their wages based on their state tax withholding information. The specific tax rate and rules vary by state.

5. Local Taxes

Some cities and counties may impose additional income taxes, often referred to as local income taxes. These taxes are often added to employees' state income tax withholding. The specific rules and rates for local taxes vary by jurisdiction. Employers will usually withhold these taxes in locations that have a local income tax.

Employer Tax Responsibilities

In addition to withholding and remitting employee payroll taxes, employers have their own tax responsibilities to ensure compliance with federal and state laws. Here's a breakdown of these:

1. Social Security Tax

As an employer, you're responsible for matching the 6.2% Social Security tax that your employees pay on their wages up to a certain annual limit. This means that for every dollar an employee pays in Social Security tax, you must also contribute an additional 6.2 cents.

You'll need to withhold the employee's portion from their paycheck and then submit both the employee and employer portions to the Social Security Administration.

2. Medicare Tax

Similar to the Social Security tax, employers are required to match the 1.45% Medicare tax that their employees pay on all their earnings. This means that for every dollar an employee pays in Medicare tax, you must also contribute an additional 1.45 cents.

You'll need to withhold the employee's portion from their paycheck and then submit both the employee and employer portions to the IRS.

3. Federal Unemployment Taxes (FUTA)

FUTA taxes fund the federal unemployment insurance program, which provides temporary financial assistance to eligible workers who have lost their jobs through no fault of their own.

As an employer, you are responsible for paying these taxes on a portion of your employees' wages. The specific FUTA tax rate is set by the federal government and is typically a small percentage of an employee's taxable wages. It's important to note that while the federal government sets the FUTA tax rate, states administer the unemployment insurance program and may have additional requirements for employers.

4. State Unemployment Taxes (SUTA)

In addition to federal unemployment taxes, most states have their own unemployment insurance programs. As an employer, you are required to pay SUTA to fund state unemployment insurance programs. These programs provide temporary financial assistance to eligible workers who have lost their jobs through no fault of their own.

The SUTA tax rate and rules vary by state, and they are typically determined by the state's unemployment rate. Employers with higher unemployment claims may face higher SUTA tax rates.

5. Local taxes

Employers in many jurisdictions may be responsible for additional local taxes, such as local income taxes or business taxes. These taxes often fund local services like schools, public safety, and infrastructure. The specific types and rates of local taxes can vary widely depending on the location of the business. Some cities may impose a payroll tax on employers, while others may have a business license fee.

To ensure compliance, it's crucial for employers to consult with local tax authorities or a tax professional to understand their specific obligations and to stay updated on any changes in local tax laws.

Streamline Tax Reporting With Paystubsnow

Accurately calculating and reporting income and payroll taxes on employee paystubs is crucial for maintaining compliance with tax regulations. If you run an organization with a large workforce, you’re already aware that it can be a lengthy and complex process.

This is where Paystubsnow is valuable; with our user-friendly online platform, we’re focused on helping businesses generate compliant and professional pay stubs.

Here's how our tool can streamline your tax reporting process:

• Automatic Tax Calculations: Paystubsnow automatically calculates both federal and state payroll taxes based on your location and employees' information. This eliminates the risk of errors and ensures paystubs accurately reflect all required tax withholdings.
• Transparent Reporting: With paystubs that clearly show all tax deductions and contributions, we make it easy for you to offer your employees a clear understanding of their take-home pay and tax withholdings. This transparency promotes trust and simplifies record-keeping for both employers and employees.
• Reduced Risk of Errors: Manual data entry can lead to costly mistakes in payroll calculations and tax reporting. Paystubsnow eliminates this risk by automating tax calculations and minimizing manual input. This ensures accuracy and saves you time and money.

With a user-friendly interface and automated features, our platform will allow you to focus on growth while removing the burden of tax calculations and paystub generation.

Simplify Your Payroll Process with Paystubsnow today!