How To Calculate Your Payroll Tax
Payroll tax calculation can be overwhelming, but it’s crucial to get it right. Follow these steps to ensure you’re accurately calculating payroll tax.
Payroll tax calculation is a vital element of managing a business. Proper calculations ensure that employees receive correct compensation and that the business complies with government reporting and taxation requirements. Tax analysts and HR managers often standardize the process by using software to run payroll. The software calculates taxes and take-home pay based on hourly or salary rates, tax rates, deductions, and applicable laws.
Small business owners may complete this process manually. But even larger organizations want their workers to know the basics without software assistance. Why? The company is ultimately responsible for proper payments, even when they contract with a third party. Taking the mystery out of tax calculations helps those responsible for payroll understand the process so they can recognize and correct any errors and stay current with any changes in requirements.
Payroll tax calculation is a broad topic spanning several areas. This article covers various types of payroll taxes, calculation steps, employer taxes, tax filing, and compliance.
What is payroll tax?
Payroll tax consists of various taxes employers must withhold from employees’ paychecks and remit to federal, state, and local governments. These taxes may include federal income tax, Social Security and Medicare, and state and local income taxes. Employers also contribute to Federal Insurance Contributions Act (FICA) taxes on behalf of their employees.
Payroll taxes fund Social Security, Medicare, and other government programs. Failure to pay can result in penalties and legal consequences. You can find more information on payroll taxes in IRS Publication 15.
The key word for payroll taxes is “employee.” Employers don’t pay payroll taxes for independent contractors or freelancers. So, they must classify contractors versus employees correctly, as this greatly impacts the taxes due for workers.
Types of payroll tax
America has one of the most complex tax systems in the world. Laws vary at the federal, state, and local levels.
Additionally, some U.S. citizens are exempt from some types of taxes, so business owners must familiarize themselves with the types of taxes and to whom they apply.
Federal income tax
Paid by: Employees
The Internal Revenue Service (IRS) collects federal income tax. This is a progressive tax, meaning the more you make, the higher your rate and taxes due.
The current structure has seven tax brackets ranging from 10% to 37%. Taxable income amounts vary for each bracket based on tax filing status. Employers must withhold a calculated amount from employee wages after deductions like 401(k) contributions and pre-tax health insurance premiums. The employee completes a Form W-4 identifying the withholding amount to be applied.
Social Security tax
Paid by: Employers and employees
Social Security tax is part of FICA taxes, with a separate line on the W-2. Employers match their employees’ contributions up to a set amount. This is 6.2% in 2023 and ends after annual salaries exceed $160,200.
Social Security is the only federal tax with a wage base limit. Like federal income tax, this rate applies to all employees regardless of filing status or exemptions.
Medicare taxes
Paid by: Employers and employees
The Medicare tax is also part of FICA taxes and has a separate line on the W-2. Employees pay 1.45% of wages, and employers match this amount.
After the threshold amount of $200,000, employers withhold an additional Medicare tax at the rate of 0.9%. These rates apply to all employees regardless of filing status or exemptions.
Federal unemployment tax
Paid by: Employers
The Federal Unemployment Tax Act (FUTA) taxes employers to help fund unemployment benefits for workers who have lost their jobs.
Employers pay 6% of wages up to a wage base limit of the first $7,000 paid to each employee. They report their contributions on IRS Form 940.
When state payroll taxes apply, this rate typically decreases from the federal level, but employers should check with the relevant agencies.
State and local taxes
Employers must pay attention to the applicable taxes in their area based on employee residency rather than a business location. These taxes vary widely by location and are also subject to change over time, so it’s important to remain aware of changes in applicable laws and regulations.
Some examples include:
- California state disability insurance (SDI). Employees pay California SDI through a mandatory tax withheld by employers. This tax is 0.9% of wages with a taxable wage limit of $153,164 per employee in 2023.
- New York City personal income tax. Effective 2018, employees within city limits must pay a revised additional local income tax. Amounts vary based on taxable wages and applicable pay frequencies, such as monthly, semi-monthly, biweekly, or weekly.
- Ohio school district income tax. Effective 2023, Ohio requires employers to withhold school district income tax from employee compensation. School district tax amounts vary, and districts can choose between using traditional or earned income.
Understanding deductions and credits
When it comes to payroll taxes, it’s important to understand pre-tax and post-tax deductions before calculating an employee’s net pay. You should also understand tax credits and how they reduce taxes owed.
Pre-tax deductions
Pre-tax deductions are taken out of an employee’s paycheck before taxes are calculated and withheld. These deductions can boost take-home pay by reducing taxable wages. Some common examples are:
- Medical and dental benefits
- Traditional IRA and 401(k) contributions
- Health savings account (HSA) contributions
Post-tax deductions
Post-tax deductions are taken out after taxes have been calculated. These deductions decrease net pay but not an employee’s tax liabilities. Some common examples are:
- Roth IRA contributions
- Individual taxable account contributions
- Union dues
- Garnishments (child support, alimony, etc.)
Tax credits
Tax filers typically apply credits when filing individual returns. Filers apply credits to outstanding tax liabilities to reduce the total payout. However, there’s at least one payroll credit that some employers can use.
Employers who pay SUTA may receive a FUTA tax credit of up to 5.4% when they file Form 940. Without this credit, employers pay 6% FUTA on the first $7,000 wages for each employee.
The federal government may also create temporary tax credits to address specific crises. For example, eligible employers received the following tax credits during the COVID-19 pandemic:
- Employee Retention Credit
- Credit for Sick and Family Leave
- Paid Leave Credit for Vaccines
The steps for calculating employee payroll tax
Calculating employee payroll taxes is a detailed but necessary task for any business. Business owners should learn the basic steps to avoid and identify errors in payroll tax calculations.
3 steps for calculating employee payroll tax:
- Determine employee’s gross pay
- Calculate employee withholding for federal, state, and local income taxes
- Calculate employee withholding for FICA
1. Determine the employee’s gross pay
To determine an employee’s gross income, calculate the total amount earned during the corresponding pay period. This includes hourly wages or salary and any extra income, such as bonuses, overtime pay, or commission.
For example, let’s say Caleb makes $15 an hour and worked 40 hours in the first week of April 2023. His weekly gross pay would be $600 ($15 x 40).
You should also add any extra income earned. In this case, Caleb received a $100 performance bonus, so his weekly gross income would be $700 ($600 + $100).
2. Calculate employee withholding for federal, state, and local income taxes
Calculating employee withholding for federal, state, and local income taxes is complex. Simplify the process by following these steps.
1. Determine the employee’s filing status and allowances
This information is found on the employee’s Form W-4. For 2020 and prior years, the W-4 form asked for an employee’s filing status (single, married filing jointly, etc.) and the number of withholding allowances claimed. The more allowances claimed, the less tax withheld.
In 2020, the IRS introduced a new Form W-4, which eliminated allowances and the use of complicated worksheets. It instead asks for additional information, such as other income, deductions, and tax credits. This updated form makes calculating withholding more accurate but requires more information from employees.
The form revision created two methods for calculating federal income tax:
- Wage bracket method. This is a simpler form of calculation that uses the pay schedule and marital status of each employee.
- Percentage method. This method uses the allowances, marital status, and taxable wages of employees to determine tax liability.
2. Determine the employee’s taxable income
Calculate this by subtracting the employee’s pre-tax deductions from their gross wages. Examples include:
- Health savings account (HSA)
- Medical and dental benefits
- Group term life insurance
- Retirement funds
3. Determine the employee’s federal income tax withholding
Once you determine the employee’s taxable income, you can use IRS Publication 15-T to calculate federal income tax withholding. This publication includes tables and worksheets you can use to determine the correct withholding amount based on the employee’s filing status, pay frequency, and taxable income.
For example, let’s say Caleb’s taxable income for this week’s paycheck is $580 ($700 gross pay minus a $120 pre-tax deduction for his retirement fund). Caleb is married and filing jointly. He’s paid weekly and his W-4 is from after 2020.
Using the 2023 Publication 15-T, you determine that Caleb should have a standard withholding of $5 per week.
4. Determine the employee’s state and local withholding
State and local income taxes vary by location. This requires researching the applicable rates in your area. You can use state tax tables or online calculators to determine the correct withholding amount.
Let’s say Caleb lives in Nevada, which has no state income tax. As a result, there are no further deductions. However, if Nevada implemented a law that required a 3% tax rate for his annual income, he’d have an additional deduction of $17.40 from this week’s paycheck.
3. Calculate employee withholding for FICA
The Federal Insurance Contributions Act (FICA) requires employers to withhold employee Social Security and Medicare taxes from each paycheck. The withholding amounts are determined by the employee’s wages and filing status.
For example, let’s say Caleb has a gross pay of $700 for the week in question. This means his Social Security withholding would be $43.40 ($700 x 0.062). His Medicare withholding would be $10.15 ($700 x 0.0145).
Calculate the employer’s share of payroll taxes
Employers must also determine how much they owe in payroll taxes at the state and federal levels. You’ll need to review and calculate three main types of taxes.
FICA
Employer portions of FICA taxes are identical to the amounts paid by employees because employers pay the matching half.
Using Caleb as an example, you’d pay 6.2% of the Social Security tax and 1.45% of the Medicare taxes. That amounts to the same $43.40 and $10.15 that Caleb would see on his pay stub.
Unemployment (FUTA/SUTA)
FUTA requires employers to contribute to federal unemployment benefits. A State Unemployment Tax Act (SUTA) has a similar requirement. Some states refer to their unemployment insurance taxes as SUI instead of SUTA. There is only one FUTA tax, but SUTA rates vary by state.
Employers pay 6% on the first $7,000 in wages for FUTA. For example, by April 2023, you’d have completed your share of FUTA payments on Caleb’s behalf. However, if he earned $700 in the first week of January 2023, you’d pay $42 ($700 x 0.06).
Nevada has unemployment insurance. You’d calculate a reserve ratio of 13.5 for the company. Using the 2023 UI table, you’d estimate that the company qualifies for a UI rate of 1.15. Caleb’s paycheck hasn’t yet reached the 2023 taxable wage limit of $40,100 limit in April, so his $700 paycheck leads to a $10.50 ($700 x 0.015) payment to Nevada from his employer.
Disability
The United States doesn’t have federal disability tax. However, some states impose a disability tax or fee, such as state disability insurance (SDI). These taxes provide benefits to workers who can’t work due to a nonwork-related illness or injury.
Employers in these states must withhold SDI taxes from employees’ wages. Some states also require an employer contribution. For example, California’s SDI is entirely employee-funded, but New Jersey requires employee and employer contributions.
Returning to the Caleb example, Nevada has no SDI. Consequently, you wouldn’t have to pay for SDI.
However, let’s say Andrew worked at your New Jersey branch last year. He earned $700 for his first paycheck in April 2023. The state set your rate at 0.2%. That led to a $1.40 ($700 x 0.002) payment from you for that paycheck.
Apply tax calculations to employee pay stub
Payroll is much easier to understand when you see the calculations in a realistic example. Let’s look at Caleb’s digital paystub for the first week of April 2023:
Caleb Santos
Pay Frequency: Weekly
Pay Period: Week ending April 7, 2023
Employer: Company XYZ
Location: Las Vegas, NV
EARNINGS $700
Hourly (40 x $15) $600
Bonus $100
TAXES - $58.01
Federal Income Tax - $5
Medicare Tax - $10.15
Social Security Tax - $43.40
DEDUCTIONS - $120
401(k) - $120
TAKE HOME PAY $521.45
Master your payroll taxes with Upwork
Accurate payroll tax calculations are crucial for avoiding costly penalties, maintaining compliance with tax laws, and ensuring the correct contribution amounts to various tax programs. Failure to accurately calculate payroll taxes can result in significant financial and reputational damage for businesses of all sizes.
Entrepreneurs often wear many hats when managing small businesses. Even so, a critical skill is knowing when to leave a particular task, such as payroll tax management, to specialists. The good news is that you don’t need to hire an entire HR team or a full-time payroll analyst. Instead, you can leverage the skill sets of payroll processing specialists on Upwork.
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This article is intended for educational purposes and should not be viewed as legal or tax advice. Please consult a professional to find the solution that best fits your situation.