Payroll Tax : Overview & Examples

What Is a Payroll Tax?

A payroll tax is a percentage withheld from an employee's pay by an employer who pays it to the government on the employee's behalf. The tax is based on wages, salaries, and tips paid to employees. Federal payroll taxes are deducted directly from the employee's earnings and paid to the Internal Revenue Service (IRS).

Understanding Payroll Taxes

In the U.S., the term federal payroll taxes refers to the taxes deducted to fund Medicare and Social Security programs. These are labeled as MedFICA and FICA on pay stubs. Federal income tax, which also is withheld from employee paychecks, goes into the general fund of the U.S. Treasury.

Most states and some cities and counties impose income taxes as well, and these amounts are paid directly to their coffers. In addition, employers, but not employees, also pay federal unemployment taxes for each of their employees.

Unlike the U.S. income tax, which is a progressive tax, some elements of payroll taxes are levied only up to a certain yearly limit. For example, any income that exceeds the Social Security wage base, set at $142,800 in 2021, is not subject to Social Security tax, making the U.S. payroll tax a regressive tax.

In addition to income taxes, payroll taxes are collected by federal authorities and some state governments in many countries, including the U.S. These payroll tax deductions are itemized on an employee's pay stub. The itemized list notes how much is withheld for federal, state, and municipal income taxes as well as the amounts collected for Medicare and Social Security payments.

Governments use revenues from payroll taxes to fund specific programs including Social Security, health care, and workers' compensation. Local governments may collect a relatively small payroll tax to maintain and improve local infrastructure and services, including first responders, road maintenance, and parks.

Unemployment Taxes

Employers bear the primary responsibility for funding unemployment insurance. If they lay off employees, those employees are entitled to unemployment benefits. The rate of unemployment insurance the employer will pay varies by industry, state, and federal fees. Some states require employees to contribute to unemployment and disability insurance.

Federal payroll taxes cover Social Security and Medicare contributions, which constitute the Federal Insurance Contributions Act (FICA) tax. An employee pays 7.65%. The premise of Social Security and Medicare is that you pay into them during your working years in order to qualify to withdraw these funds after retiring or under certain medical circumstances. This rate is divided between a 6.2% deduction for Social Security on a maximum salary of $142,800 and a 1.45% share for Medicare.

There is no salary limit on Medicare, but anyone who earns more than $200,000 — or $250,000 for married couples filing jointly — pays another 0.9% for Medicare.

Employees pay 6.2% into Social Security for the first $142,800 earned in 2021 and another 1.45% into Medicare on all wages.

Special Considerations

Self-employed individuals including contractors, freelance writers, musicians, and small business owners are also required to remit payroll taxes. These are referred to as self-employment taxes.

Unlike most salaried workers, people who are self-employed don't have employers to remit payroll taxes on their behalf. This means they must cover both the employer and employee portions of the tax on their own.

The self-employment tax rate is 15.3%. There are two parts to this rate including a 12.4% contribution to Social Security — old-age, survivors, and disability insurance — and a 2.9% payment to Medicare. Another 0.9% surtax for Medicare applies to self-employment earnings that exceed $200,000.

Social Security Payroll Tax

Funds paid to Social Security taxes go into two trust funds: the Old-Age and Survivors Insurance (OASI) Trust Fund, which pays retirement and survivor benefits, and the Disability Insurance Trust Fund, for disability benefits. The Secretary of the Treasury, the Secretary of Labor, the Secretary of Health and Human Services, the Commissioner of Social Security, and two public trustees manage these trust funds.

President Franklin D. Roosevelt signed the Social Security Act into law on Aug. 14, 1935, to provide a safety net for the disabled and retirees. When the program was conceived, high-wage earners were exempt from paying into the fund and from receiving Social Security benefits. But that exemption was eliminated and replaced with a cap by Congress which has continued to rise roughly at the same rate as wages.

Medicare Payroll Tax

As noted above, payroll taxes also go toward Medicare. These payroll deductions go into two separate trust funds: the Hospital Insurance Trust Fund and the Supplementary Medical Insurance Trust Fund.

Individuals enrolled in Medicare pay a monthly income-based fee for basic Medicare coverage and are responsible for a portion of their medical costs.

Payroll Taxes vs. Income Taxes

There is a distinction between a payroll tax and an income tax, although both are deducted from paychecks. Payroll taxes are used to fund specific programs. Income taxes go into the general funds at the U.S. Treasury.

Everyone pays a flat payroll tax rate, up to a yearly cap. Income taxes, however, are progressive. Rates vary based on an individual's earnings.

State income tax, if any, goes into the state's treasury.