How To Calculate Payroll Taxes – A Guide for Business Owners

Whether you are a small business owner or the CEO of a multinational corporation, understanding how to calculate payroll taxes can save you a lot of trouble in the long run. It’s necessary to keep up with how U.S. payroll taxes and regulations change over time, as even the most minor infractions can lead to Internal Revenue Service (IRS) penalties, hefty interest charges and accruals, audits, legal issues, and reputational damage.

The best way to avoid these kinds of problems is to develop an in-depth understanding of payroll taxes and what tools can assist you in maintaining error-free payroll records and tax filings. In this guide, you’ll find more information about different types of payroll taxes as well as helpful resources for completing your taxes more efficiently and accurately.

Key Takeaways

  • Tax rates may change from year to year; before filing, confirm all relevant rates with the appropriate authorities.
  • Various forms, including Form W-4, can help employers collect the information they need to complete payroll taxes correctly.
  • Both employers and employees can benefit from tax deductions and credits. A tax professional can help you determine which ones apply to you.
  • If your taxes have grown in complexity, it may be time to hire a tax professional or invest in payroll software.

Understanding Payroll Taxes

With the various federal, state, and local taxes that impact employees’ wages, it can be difficult to identify all applicable taxes and perfect your payroll runs for absolute compliance. To achieve the best possible results, your organization’s leaders must understand what payroll taxes are, the different types of taxes that apply, and how you can best collect and maintain the information necessary to file payroll taxes.

Definition of Payroll Taxes

Payroll taxes are taxes imposed on employers and employees based on employees’ taxable incomes, which may include salaries, bonuses, commissions, tips, and more. These taxes are calculated based on preset tax rate percentages — determined by government entities — and are levied at federal, state, and local levels.

Types of Payroll Taxes

Several federal taxes impact all employers and employees, while unique state and local taxes apply to your particular workforce or individual members. These are the main types of payroll taxes:

  • Federal Income Tax: Both employers and employees are responsible for paying federal income taxes, which are taxes to the federal government that are based on your total income and corresponding tax bracket. Federal income taxes are collected by the IRS through withholdings, quarterly payments, and annual tax filings.
  • Social Security Tax: This federal tax funds retirement, disability, and survivorship benefits offered through the Social Security Administration (SSA). This is a tax that both employees and employers must pay.
  • Medicare Tax: This federal tax funds the United States Medicare program, which extends health insurance benefits to U.S. citizens and permanent residents who are 65 years or older. This is a tax that both employees and employers must pay.
  • State and local taxes: State and local taxes can impact either employers or employees, depending on where the organization operates and where employees live. These taxes vary widely, but some common examples include state disability or unemployment insurance taxes, gross receipt taxes, and local school district taxes.

Employee Information Gathering

The best way to file payroll taxes accurately is by proactively gathering relevant demographic, tax, and other information from your employees, typically through Form W-4.

Required Employee Details for Payroll Tax Calculations

  • Social Security Number: This 9-digit form of personal identification is assigned to all U.S. citizens by the SSA at birth or to new residents upon immigration. Other personally identifiable information collected for payroll taxes includes names and mailing addresses.
  • Filing status: The five possible filing statuses — Single, Married filing jointly, Married filing separately, Head of household, and Qualifying widow(er) with dependent child — help employers ascertain how much income tax they should withhold from an employee’s paychecks. Employers can find this information on Form W-4.
  • Withholding information: Traditionally called withholding allowances on older versions of Form W-4, withholding information covers an employee’s filing status, dependents, whether they have multiple jobs or a working spouse, and other details that may affect how much income tax should be withheld. Employers can collect and find this information on the updated Form W-4 and similar state-based forms.

Federal Income Tax Calculation

Federal income taxes are taxes paid to the federal government on an annual basis and are calculated based on an employee’s annual income. The tax is a percentage of their total earnings and is determined based on the tax bracket within which their income falls.

Using the IRS Tax Tables

The IRS tax tables can help employees determine how much they owe in federal income taxes for that year based on their annual income, filing status, and any changes that have impacted tax brackets or rates since their previous annual filing.

  • Single vs. Married withholding: Withholding tables for single filers typically result in higher withholdings per paycheck compared to married people who file jointly. In the IRS Tax Table, each of these filing statuses is represented in its own column so you can identify your tax amount according to your status.
  • Calculating taxable income: All household income — minus relevant deductions — is considered taxable income for the federal government. The result of this calculation is what you should search for in the IRS Tax Table.
  • Deductions and credits: All relevant deductions should be subtracted from your annual income before calculating your federal income taxes. Once your taxes have been calculated, credits should be subtracted from that number for your true total.

Social Security Tax Calculation

The Social Security tax is collected by the SSA to fund various benefits for eligible U.S. citizens. All employed workers and their respective employers are responsible for paying social security taxes on an annual basis.

Determining Taxable Wages

To determine taxable wages, you’ll need to consider all wages earned, including salaries, overtime payments, bonuses, tips that amount to more than $20 in a calendar month, commissions, and income that comes from self-employment.

While some deductions like health insurance premiums and retirement contributions impact federal income taxes and taxable income, these deductions do not impact Social Security taxes.

Calculating Social Security Tax Rate

The current set tax rates for Social Security are 6.2% for the employer and 6.2% for the employee, amounting to a total of 12.4%. For example, if an employee earns a taxable income of $50,000 per year, the employer will owe 6.2% of $50,000 — $3,100 — in Social Security taxes for that particular employee. The employee will also owe $3,100 for Social Security taxes that year. Self-employed individuals will be responsible for the full 12.4%, or $6,200.

Social Security Wage Base Limit

Social Security is the only federal tax that includes a wage base limit, otherwise known as maximum taxable earnings. Once an employee’s annual earnings surpass a set number from the IRS, they will not be taxed for any income earned beyond that threshold. In the year 2024, the wage base is set at $168,600.

Medicare Tax Calculation

Medicare tax is a federal tax on employers and employees that was first established by the Additional Medicare Tax and Affordable Care Act (ACA) in 2013. Below, you can learn more about how to calculate and understand medicare taxes within the context of your payroll:

Calculating Medicare Tax Rate

Medicare tax rates are currently set at 1.45% for employees and 1.45% for employers, for a total of 2.9%. For example, if an employee earns a taxable income of $50,000 per year, the employer will owe 1.45% of $50,000 — $725 — in Medicare taxes for that employee in that tax year. The employee will also owe $725 for their portion of the Medicare tax. For self-employed individuals, their tax rate will be the full 2.9% of $50,000, amounting to $1,450.

No Wage Base Limit for Medicare Tax

Unlike the Social Security tax, there is no wage base limit for Medicare. This means that, regardless of how much you earn, all income will be taxed at the Medicare tax rate. So, even if you earn $200,000 and qualify for the wage base limit on Social Security taxes, you and your employer will each have to pay a 1.45% Medicare tax rate on the full $200,000 earnings for that year.

State and Local Tax Considerations

Every state and local region approaches taxes differently. Some employers and employees are subject to both city and state taxes, while others may not even be required to pay a state income tax.

  • State-specific withholding requirements: Each state decides how much should be withheld from employee paychecks to pay state income taxes. States can set tax rates and brackets that may differ greatly from federal tax rates and brackets. Some states also have unique withholding agreements with other states called reciprocal agreements, which allow employees to work in a neighboring state but follow tax rules for their state of residence.
  • Local tax considerations: Local taxes may be applied to either employers or employees at the discretion of their community. Local school district taxes are some of the most common, while larger cities like New York also levy additional taxes on their residents.

Deductions and Credits

Deductions can decrease your taxable income, and credits can decrease your actual taxes, at least for the federal income tax. Learn more about each of these options below:

Tax Credits and Their Role in Reducing Tax Liability

While deductions focus on reducing the amount of your income that is considered taxable, credits directly decrease the actual taxes you’ll end up owing, regardless of the actual tax bracket you fall under. So, for example, if you owe $4,000 in taxes but earn a $500 credit, you’ll only owe $3,500. The government designs these tax credits to incentivize positive behaviors, whether that’s contributing to the economy in a certain way or benefiting the environment by using energy-efficient technologies in your home office.

Common Deductions and Credits for Employees

  • Standard deduction
  • Itemized deductions
  • Retirement contributions
  • Earned Income Tax Credit (EITC)
  • Child Tax Credit (CTC)
  • American Opportunity Tax Credit (AOTC)
  • Energy Efficient Home Improvement Credit

Payroll Tax Compliance

Accurately paying your taxes is a legal obligation in the United States, meaning anyone who does not comply with tax compliance laws may owe penalties, fines, or interest to the IRS. Depending on the severity of noncompliance, civil or criminal charges may also be brought forth.

Tax laws change frequently, as do the forms, rates, and expectations that come with filing them. While it can be challenging to keep up with these changes on your own, many payroll software solutions are designed to stay up-to-date with the changing payroll tax landscape. You can learn more about some of the best payroll software in our guide.

Reporting and Filing Requirements

When employers hire employees, they should expect to file several different tax forms each year on behalf of this workforce. Bear in mind that the following forms are those that must be filed by employers for traditional, full-time employees. Other forms, such as Form 1099-MISC, may need to be filed for workers like contractors and freelancers.

Key Forms for Reporting Payroll Taxes

  • Form 941: Form 941 is a quarterly tax return used by U.S. employers to document and report the income, Social Security, and Medicare taxes withheld from employee paychecks as well as the contributions employers themselves make to Social Security and Medicare taxes.
  • Form W-2: Form W-2 is completed by all employers for each employee on their payroll. The form lets the IRS and SSA know employees’ wages and their withholdings.
  • Form W-3: Form W-3 must be filled out by all employers who employ at least one W-2 employee. Aggregated employee income is reported to both the IRS and the SSA through this form.

Using Payroll Software to Calculate Taxes

Whether you’re an employer or an employee, it may be beneficial to hire a tax professional to manage your taxes as they grow more complex. Working with a dedicated tax professional can help you stay abreast of changing tax rates and regulations, identify optimal deductions and credits, manage multiple income streams or employee types, and even prepare for and respond to IRS audits and communications.

But if you prefer self-service accessibility, a growing number of accounting and payroll software solutions offer the compliance, real-time updates, and knowledge bases necessary to maintain payroll and taxes compliantly. Rippling, ADP, and Gusto are some of the leading solutions in this area; for additional options and in-depth analyses of each of these tools, read about The Best Payroll Software – Top 10 Compared for 2024.

Conclusion: Calculating U.S. Payroll Taxes Effectively

While getting every detail of your payroll taxes right can be tedious, time-intensive, and all-around difficult, developing a clearer understanding of the different types of taxes and what employers and employees need to complete them effectively makes the process run much more smoothly. Additionally, accessing the right resources and investing in relevant assistive software can help you feel more self-assured in the payrolls you run and taxes you file.

Whether you’re confident in your ability to file your payroll taxes or think it’s time to hire professional support, these resources can help you move forward with the answers you need:

FAQs

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Shelby Hiter

Shelby Hiter is a technology writer and editor who previously managed editorial strategy for TechRepublic, Webopedia, LinuxToday, and SoftwarePundit. Her work has appeared in online publications such as TechRepublic, eWeek, Datamation, eSecurity Planet, Enterprise Networking Planet, CIO Insight, Project-Management.com, Insurance Thought Leadership, and AllBusiness.com. Over more than five years of working in this space, she has developed particular expertise in artificial intelligence, big data, project management, open-source software, HR, healthcare tech, and fintech. She also specializes in marketing and communication strategies as well as academic writing. Shelby holds a master's degree in Humanities from the University of Chicago. Follow or…