How Payroll Taxes are Calculated: A Quick Guide to the Essentials

Payroll taxes - we all have to pay them and as a business owner you have to calculate, deduct and remit the payroll taxes for your employees. How fun is that? Most of your employees know even less than you about these taxes. Some may secretly think you are finding ways to reduce their hard-earned wages.

You basically have an unpaid role as a tax collector for the government. It’s no fun but it’s part of the deal when you are a small business owner with employees.

Most accounting systems provide some help in calculating and remitting your payroll taxes. But understanding what is going on behind the scenes will help you answer questions for you and your staff.

TYPES OF TAXES

There are 3 main types of federal payroll taxes that every employer needs to know about:

  • Federal Income Taxes (FIT)
  • FICA (which is actually a combination of 2 taxes – more on that later) and
  • Federal Unemployment Taxes (FUTA)

You might also have state income taxes and other types of state payroll taxes depending on what state (or states) you have employees. Knowing which state payroll taxes you and your employees are subject to and which state your employees work in (referred to as nexus) can be a bit tricky. The best resources are usually on your state’s government websites or from your payroll provider. Click here for a good article with an overview on how to follow individual state tax laws.


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FICA

FICA stands for Federal Insurance Contribution Act. You might win some money in a “useless trivia” contest with that knowledge. What is important to know is how to calculate FICA and where the money goes.

Something your employees may not realize is that as an employer you are footing half the bill for FICA. The rate employees and employers pay is the same. For most people, FICA taxes are 7.65% of taxable earnings and as an employer you match that amount. Put another way, employees are only paying half of their FICA bill – as their employer, you are paying the other half!

There are two parts to FICA – Social Security and Medicare.

Social Security

The first part of FICA is a contribution to Social Security. According to ssa.gov:

"The Social Security program in the United States provides protection against the loss of earnings due to retirement, death, or disability."

Most employees think of retirement when they think of social security. But social security goes to support those that relied on a deceased person for support including minor children and spouses. Social security also can provide benefits to workers that become disabled.

Social Security payroll taxes are calculated at 6.20% of taxable earnings. If an employee makes over $142,800 for 2021, they will only pay social security taxes on the first $142,800 of taxable earnings.

Medicare

The second part of FICA is a contribution to Medicare. According to medicare.gov:

Medicare is the federal health insurance program for:
▪ People who are 65 or older
▪ Certain younger people with disabilities
▪ People with End-Stage Renal Disease


Medicare payroll taxes are calculated at 1.45% of taxable earnings. There is no cap on Medicare taxes. There is a premium tax of 0.90% for employees that have taxable earnings exceeding $200,000. Good news – there is NO employer match on the Medicare premium tax.

UNEMPLOYMENT TAXES

Federal unemployment taxes (FUTA) are employer-paid. The FUTA tax rate is currently 6.0% on the first $7,000 in wages per employee each year. However, employers usually receive a 5.4% FUTA tax credit reduction when they file their Form 940. This results in a net FUTA tax rate of 0.6%.

The only state or territory that does not receive the full 5.4% FUTA tax credit reduction right now is the Virgin Islands.

There is a chance that more states will lose their credit reduction in 2022. This article discusses that scenario:
tax.thomsonreuters.com

TAXABLE EARNINGS & PRETAX DEDUCTIONS

We’ve used this term several times – what exactly does that mean?

Taxable earnings for our purposes usually means regular wages (salary) less pretax deductions. The most common pretax deductions are:
        ●  Health Insurance Premiums
        ●  Group Term Life Insurance
        ●  Retirement Plans
Pretax deductions reduce the amount of taxable wages for the employee and often for the employer as well.

Pretax deductions can be tricky – some reduce FIT, FICA, and FUTA – others only reduce FIT. Below is a table of common pretax deductions and their tax treatment per the IRS Publication 15, Section 15.

Deduction Type

FIT

FICA

FUTA

Accident and Health Insurance Premiums *

Feature 1

Feature 1

Feature 1

Feature 2

Feature 2

Feature 2

Feature 2

Retirement & Pension Plans

Employer Contributions to a Qualified Plan

Exempt

Exempt

Exempt

Elective employee contributions and deferrals to a 401(k)

Generally Exempt (3)

Taxable

Taxable

Employer contributions to individual retirement accounts under simplified employee pension (SEP) plan

Generally Exempt (4)

Exempt (5)

Exempt (5)

Employer contributions to section 403(b) annuities including salary reduction contributions

Generally Exempt (3)

Taxable (6)

Taxable (6)

Employee salary reduction contributions to a SIMPLE retirement account

Exempt

Taxable

Taxable

Distributions from qualified retirement and pension plans and section 403(b) annuities. See Pub. 15-A.

Taxable (7)

Exempt

Exempt

Employer contributions to a section 457(b) plan

Generally Exempt (3)

Taxable

Taxable

Employee salary reduction contributions to a section 457(b) plan

Generally Exempt (4)

Taxable

Taxable

* This includes contributions to health, vision, and dental insurance plans, Health Savings Accounts (HSA), and Flexible Savings Accounts (FSA)
(1)  Except 2% shareholder-employees of S corporations
(2)  Except for the cost of group-term life insurance includible in the employee's gross income. Special rules apply for former employees.
(3)  See section 402(g) for limitation
(4)  See section 402(g) for salary reduction limitation
(5)  Except for amounts contributed under a salary reduction SEP agreement
(6)  If paid through a salary reduction agreement (written or otherwise)
(7)  But recipient may elect exemption on Form W-4P in certain cases; mandatory 20% withholding applies to an eligible rollover distribution that isn't a direct rollover; exempt for direct rollover. See Pub. 15-A.

One thing to note, employer-paid healthcare is not considered income to the employee and is not a pretax payroll deduction. Instead, businesses deduct health plan costs on their business taxes.

There is another category of employee compensation known as supplemental wages. These wages include:

  • Commissions and Bonuses
  • Severance Payments
  • Taxable Prizes and Awards
  • Retroactive Pay Increases
  • Reimbursements of Nondeductible Moving Expenses
  • Taxable Fringe benefits
  • Some Expense Reimbursements and Allowances

Taxable earnings that are not supplemental wages are taxed using the information on your employee’s W-4 (discussion of form W-4 coming up next!). Supplemental wages do NOT use the W-4 but instead tax these wages at a flat 22%. If an employee has supplemental wages exceeding $1 million then the employer must tax those wages at the highest federal tax bracket.

FEDERAL INCOME TAXES

Everybody’s favorite tax! And the most complex. Some sources differentiate between “payroll taxes” and “income taxes.” But for this article, we are assuming that any taxes deducted from payroll is a payroll tax – federal and state income taxes are just one of the three types.

CALCULATING FEDERAL INCOME TAXES

First step is to have your employee complete IRS form W-4. The form itself has instructions on it but the IRS has also provided step by step instructions on their website.
Often employees will ask for help in filling out their W-4. The IRS has a Tax Withholding Estimator tool on their website which can get you out of the hot seat and still provide your employee with guidance.

The IRS also covers the situation where an employee fails to provide you with a W-4 form. The default withholding assumes your employee:

  • Checked the Single or Married filing separately box in Step 1
  • Steps 2, 3, and 4 are blank

Please note, the IRS changed its form W-4 between 2019 and 2020. The IRS has detailed instructions on how to work with a W-4 from 2019 or earlier.

Letting your accounting or payroll system calculate federal taxes is the best way to deal with the onerous process. The IRS does give detailed step by step calculations and lookup tables for manual calculations. However, it is a tedious process which has to be redone with each individual employee.

I am going to walk you through a (relatively) simple calculation so you can have a high-level idea of how federal income taxes are calculated. In this example, we assume this person only has one job, no dependents and has not requested that you withhold additional taxes on their W-4. This person has checked Single or Married filing separately and left everything else blank on their W-4. It is the default withholding scenario mentioned earlier.

Each year, the IRS issues a press release in the Fall with the new marginal tax rates and the updated standard deduction amount. Here's a sample from their site:

We will use the 2022 rates for an individual single tax payer making $50,000 per year. We will assume this person has no pretax deductions. If your employee did have pretax deductions, those deductions would further reduce the taxable wages.

The first thing we need to do is estimate taxable wages for FIT purposes. We need to subtract the standard deduction ($12,950 for 2022) from the gross wages of $50,000. This gets us to $37,050 in taxable wages.

By looking at the IRS press release, we can see that puts this employee in the 12% tax bracket. But 12% is actually their marginal rate. If we multiplied $37,050 times 12% the calculated taxes would be too high. The first $10,275 of taxable wages is taxed at the lower tax bracket of 10%. So, the actual annual taxes look like this:

$10,275 x 10% = $1,027.50
+ $26,775* x 12% = $3,213.00 *Wages taxed @ 12% = $37,050 - $10,275
Total taxes = $1,027.50 + $3,213.00 = $4,240.50

Notice if we calculated the employees effective tax rate, it would be approximately 8.5%. We calculate the effective tax rate by dividing the actual taxes owed into the gross wages ($4,240.50/$50,000=8.5%).


You can see how the calculation can get rather complex as you add in pretax deductions, lookup standard deductions and tax brackets by employee and take into account dependents and other items on your employee’s W-4. This unpaid job of working for the IRS is getting harder by the minute!


Now that you know more than you ever wanted to know about payroll taxes, go get yourself a cup of coffee. You deserve it!

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By Cindy Leaver
Cindy Leaver is a strategic thinker and a motivational and adaptable leader with experience leading finance, technology, operations, marketing and people functions. She is a CPA with over 25 years of business experience.

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