Payroll Tax vs. Income Tax

When considering mandatory tax withholdings, you must familiarize yourself with payroll tax vs. income tax. Both are types of employment taxes, but they are separate tax deductions. Make sure you understand both income tax and payroll tax, how they compare, how to calculate each, and how to properly meet employer responsibilities for these taxes.

What Is the Difference Between Payroll Tax and Income Tax?

Use the chart below to understand the differences between payroll tax and income tax: who pays them, how they are calculated, and what the taxes go toward.

What Are Income Taxes?

Income taxes are withholdings from employees' paychecks that cover what they will owe in federal income tax for the year. The actual amount that will be withheld is based on information employees provide on Form W-4. This is where, upon hire, employees indicated their marital status, whether additional withholding should be made to cover certain personal taxes, and whether they may be entitled to deductions that would reduce their income taxes (e.g., claiming dependents may make them eligible for tax credits).

In addition to federal income tax, most states require employers to withhold state income tax from employees' paychecks, except for the following states with no income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Some cities, including New York City and Denver, also have local income taxes, which can result in additional wage withholdings. Get a full breakdown of payroll taxes by reading our payroll tax guide for employers.

Who Pays Income Taxes?

The employee is solely responsible for paying income taxes and reporting that information on their tax return each year. While employers don't pay for employees' income tax, they are still responsible for deducting the correct amount of income taxes from their paychecks each pay period.

If you're self-employed, who pays income taxes? Generally, you are required to file an annual return and pay estimated taxes quarterly, including self-employment (SE) tax and income tax. These taxes are not automatically withheld from wages the same way as with W-2 employment.

How To Calculate Income Tax

Knowing how to calculate income tax first requires understanding how the system is set up. Federal income tax is not one flat rate. Instead, the U.S. uses a progressive tax system, meaning that as your income reaches a higher tax bracket, the money that falls into that bracket gets taxed at a higher rate. Tax brackets will also vary depending on factors such as filing status (single, married filing jointly, married filing separately, head of household).

How high are state and local income tax rates? The answer depends on the specific state and locality, each with its own income taxes set up as a flat or progressive rate or a specific dollar amount. For example, New York City has a 3.876% tax rate, while Denver's rate is $9.75 per month.

To determine how to calculate federal income tax and how much to withhold, you can follow these steps:

• Refer to the withholding tables in IRS Publication 15T, or Circular E.
• Choose between the wage bracket method or percentage method, which the IRS uses to calculate federal income tax withholding.
• Gather information such as pay frequency, each employee's total earnings for the pay period, and Form W-4 details.
• Account for any employees exempt from federal withholding.

While you can follow these steps each pay period for calculating income tax on your own, you can also simplify the process with help from a payroll service, which will automatically calculate federal income tax withholding each time you run payroll.

Income Taxes Example

To understand more, let's look at a basic income tax example. An employee named Taylor files as single and has $50,000 in taxable income for the year. Based on IRS tax rates, their tax rate is 22%, but they don't pay 22% of their total income in taxes. Instead, under a progressive tax system, Taylor pays 10% on the first bracket, 12% on the income that qualifies in the second bracket, and 22% on the income that qualifies in the third bracket.

Taylor's federal income taxes would be: ‍

• 10% of the first $11,000 = $1,100; plus
• 12% of the amount over $11,000 = $5,880; plus
• 22% of the amount over $44,725 = $1,160.50
• Total federal income tax = $8,140.50

What Are Payroll Taxes?

Payroll tax is different from income tax. Payroll taxes are federal and state taxes related to an employee's taxable compensation. Payroll taxes help the government pay for social programs like Social Security and Medicare, which assist the retired or disabled. FUTA, a federal tax, helps pay for those who have lost their jobs. The amount of money taken out of each paycheck depends on what the employee indicated on their W-4 form when they were hired.

Payroll taxes include:

• Income tax withholding based on information provided by employees on Form W-4. As mentioned earlier, this tax is paid entirely by employees.
• Federal Insurance Contributions Act (FICA) tax, which comprises Social Security and Medicare taxes. The Social Security portion is referred to as Old Age, Survivors, and Disability Insurance, or OASDI, and provides benefits to retirees, spouses and former spouses, dependent children in some cases, and disabled individuals under retirement age. The Medicare portion allows those age 65 and older (and certain other individuals) to qualify for Part A Medicare coverage at no additional cost, plus coverage through Parts B, C, and D for an additional premium.
• FUTA, which is a federal unemployment tax.
• State unemployment tax and SUTA programs.

Who Pays Payroll Taxes?

Payroll taxes, such as FICA, are paid for by the employer and the employee. FUTA contributions are paid entirely by the employer. SUTA and state unemployment programs are funded via employer tax, although a few states require some employee contributions.

Regarding self-employed individuals, payroll tax is the same as income tax: Contractors and the self-employed are responsible for handling tax obligations independently. Businesses that engage them are not responsible for any employment taxes on payments made to them. The self-employment tax these individuals pay on their net earnings is essentially the employee and employer share of FICA.

How To Calculate Payroll Tax

Calculating payroll tax withholding involves looking at the employee's W-4 form and other information like salary and deductions.

Unlike income tax rates, payroll tax rates are set annually:

• Social Security: 6.2% for the employer and employee (applies to the first $168,600 in wages for the 2024 tax year).
• Medicare: 1.45% each for the employer and the employee. Employers withhold an additional 0.9% once an employee's cumulative wages are above $200,000 per year.
• FUTA: 6% on the first $7,000 paid to each employee during the year, which is paid fully by the employer. Employers can receive a credit for state unemployment tax of up to 5.4%, bringing the net federal rate down to 0.6%, or a maximum FUTA payment of $42 per employee.
• SUI/SUTA: Percent and wage base vary depending on the state in which the employee resides. New employers often pay a flat rate for a few years and then move to a rated schedule based on how much they have contributed to the state's unemployment fund.

Payroll Taxes Example

Based on the tax rates outlined above, let's look at the payroll taxes for the employee mentioned earlier who makes $50,000 per year. Taylor is paid bi-weekly, so on each paycheck, their payroll tax withholding would look like:

• Wages per paycheck: $1,923 (gross)
• Social Security tax: $119 (6.2% of $1,923)
• Medicare tax: $27.88 (1.45% of $1,923)
• Total FICA taxes paid = $146.88

Remember that employers also shoulder some of the payroll tax responsibility. In this instance, the employer withholds the following amounts per paycheck:

• Social Security tax: $119 (6.2% of $1,923)
• Medicare tax: $27.88 (1.45% of $1,923)
• FUTA tax: $11.50 (0.6% of $1,923)
• SUTA tax: $52 (2.7% of $1,923)
• Total employer portion of payroll taxes = $210.38

In this example, the taxable wage base is $7,000. Once Taylor's gross wages exceed this amount, the employer no longer has to pay FUTA or SUTA taxes for that year. Also, because Taylor's wages were below the $168,600 wage base limit for Social Security and the $200,000 threshold for Medicare, FICA withholdings will stay the same for the employer throughout the year.

Knowing the Difference Between Payroll and Income Tax Is Critical

Employers' payroll tax responsibilities are extensive. And when rules change or payroll taxes vs. income taxes questions arise, these obligations can feel overwhelming. Even so, ignorance of employment tax law doesn't protect you from potential penalties. Get tax expertise on your side and consider outsourcing to a payroll services provider.