Payroll taxes and income taxes get lumped together when people complain about “taxes” taking a bite out of their paychecks. It is easy to confuse them. So what is the difference between payroll and income taxes?
From an employer’s standpoint, you end up registering the information for both on the same form. You also deposit all the funds at the same place, the IRS. Nonetheless, there are some subtle distinctions between the two. It is important for a business owner to understand these distinctions. Here is what to know:
What is a payroll tax? How is it different, and what does it mean to you? To put it simply, payroll tax represents a contribution to two federal agencies, Medicare and Social Security. Collectively, these departments fund disability, health, retirement, and survivor benefit plans.
Medicare and Social Security exact a flat, or unchanging, rate of withholding that equals 7.65%.This is the percent you automatically withhold from your employee’s gross earnings.
For example, if an employee’s gross earnings for one check equaled $800, you would multiply that by.0765 to get $61.20.This is the portion you would withhold and deposit with the IRS.
Social Security makes up 6.2% of the 7.65% tax equaling $49.60. Meanwhile, Medicare at the flat rate would account for 1.45%, equaling $11.60.
Unlike Social Security, Medicare rates can change. For employees earning over $200,000 annually, you withhold and pay an additional .9%. This raises an individual’s Medicare withholdings up to 2.35% and total payroll tax to 8.15%. However, as an employer, your contribution will stay at the 7.65% rate.
At the federal level, the funds you deposit come entirely from employee withholdings. There is no employer contribution. An employee’s federal income tax calculation begins with their Form W-4. This form should be submitted by any new hire before he or she starts working. It includes an employee’s filing status, personal exemptions, and additional withholding requests.
A worker’s W-4 and total income are used in conjunction with IRS Publication 15. This is the definitive source for calculating an individual employee’s withholdings. By referencing this publication, employers have the option of calculating each employees’ withholdings by way of percentage or tax bracket.
You must also consider state and local taxes. States’ income taxes often require procedures similar to federal laws, but you need to research your specific area. Some areas also have local income tax laws, which may vary greatly as well. You will want to check with an employee’s city, for example, to see what you must withhold from their check.
Why The Distinction Is Important
An employer gives out orders and paychecks. A boss instills confidence in his or her workers. Ideally, you want to be a boss, and you can do that simply by understanding why you are withholding your employees’ income in the first place. That way, you can explain these little details more easily when an employee asks.
Also, things happen. In the case of a pandemic, a government mandate on payroll deferral can change income, Medicare, or Social Security withholdings. You will need to know the game to follow the new rules.
Just because Form 941 consolidates tax information doesn’t mean you can add all the information together and put it on one line. There are separate lines for separate taxes, and you need to know what they are and how they work.
Finally, payroll tax requires a matching contribution from employers and income tax does not. You need to know how this works to stay compliant. In short, the more you know, the better informed you are and the more efficiently you can run your business and care for your employees.