What’s the Difference Between Payroll Tax & Income Tax?

One of the key details that sets payroll tax and income tax apart lies in uncovering who pays for which tax. Employees pay for both income and payroll taxes, while employers only contribute to payroll tax payments.

Each tax type has a specific purpose and, therefore, entails distinct ways to calculate and determine the correct amount to withhold from employee earnings and business income.

Keep reading this article to get an in-depth explanation of the key differences between payroll tax and income tax.

Key Takeaways

• The main difference between a payroll tax vs. income tax is that both income and payroll taxes are levied on employee earnings. Meanwhile, employers only pay payroll taxes.
• Income taxes follow a progressive tax rate, while payroll taxes are imposed using a flat tax rate.
• Some payroll taxes are paid for by employers, and these are FUTA and SUTA taxes. FICA taxes are split between employers and their staff, while self-employed individuals pay the full percentage of Medicare and Social Security taxes.
• Income taxes are determined by the employment, income, and household information declared by employees on their Form W-4. Tax brackets and filing status also play a key role.

Payroll Tax vs. Income Tax

Below is a breakdown of the key differences between payroll tax vs. income tax:

What is Payroll Tax?

Payroll tax is a type of tax imposed on an employee’s salary or wage, but in contrast to income taxes, payroll tax is paid by both employers and employees at the same flat rate.

Primarily, payroll taxes help fund government programs designed to provide healthcare, unemployment, and disability assistance.

In truth, payroll taxes provide the second-largest resource for the federal and state governments.

The taxes that comprise payroll taxes are FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act), and SUTA (State Unemployment Tax Act). FICA tax contributions are used to fund the government’s Medicare and Social Security programs.

FICA Taxes

The tax rates for FICA are as follows: 12.4% for Social Security and 2.9% for Medicare. However, employers and employees share the burden of paying FICA taxes, which means both parties pay 6.2% for Social Security and 1.45% for Medicare, respectively.

Self-employed individuals are also required to pay FICA taxes. Unlike employees, they pay the tax rates in full.

FUTA and SUTA

FUTA and SUTA taxes are both used to fund unemployment assistance benefits. Employers pay FUTA taxes fully, but for SUTA, only three states require both employers and employees to pay the said tax.

These states are Alaska, New Jersey, and Pennsylvania.

The tax rate for the Federal Unemployment Tax Act is 6%, and employers only have to pay FUTA on the first $7,000 worth of wages paid to their employees per year. Anything beyond $7,000 is not subject to FUTA taxation.

In most cases, employers can reduce their FUTA tax liability if they qualify for a 5.4% tax credit. Employers can do this by filing IRS Form 940, and if they qualify for the tax credit, they are then subject to a reduced FUTA tax rate of 0.6%.

Unfortunately, employers who are based in what the IRS categorizes as a credit reduction state may not be granted the FUTA tax credit.

A credit reduction state is a state that has taken a loan from the federal government to cover its liabilities on state unemployment taxes but failed to repay the borrowed amount in two years.

While FUTA and FICA are both mandatory, SUTA taxes are not required across all states and locales in the U.S. The only states where employers withhold SUTA taxes from employee income are New Jersey, Alaska, and Pennsylvania.

New Jersey imposes a 0.425% tax rate, 0.51% in Alaska, and 0.06% in Pennsylvania.

How to Calculate Payroll Taxes

Payroll taxes are calculated each time a pay period is completed. For Social Security taxes, multiply the gross wage or salary of each employee by 6.2%. To calculate Medicare taxes, multiply employee earnings by 1.45%

Following the formulas above, if an employee earns $3700, their Social Security tax is $229.4, and their Medicare tax is $53.65.

Employers pay the 6% FUTA tax rate on the first $7,000 worth of employee wages paid annually. SUTA tax rates differ per state, even in states where both employers and employees split the tax payments.

What is Income Tax?

Income tax is also imposed on employee earnings, but unlike payroll tax, it is exclusively paid by an employee. The IRS also imposes income taxes on other sources of income, including capital gains, investment income, commissions, and rent payments.

Paying income taxes is also not limited to employees alone. Businesses, legal entities, associations, and organizations also pay income taxes levied on their income.

Federal income taxes imposed on employee earnings are progressive, which means the tax rates increase as an employee’s tax bracket goes up. Tax brackets refer to a scale or range of income grouped together with a corresponding income tax amount.

Determining the amount to withhold from employee wages and salaries for their income taxes also depends on their filing status.

The different filing statuses are as follows: single, married filing separately, married filing jointly, head of household, and qualifying widow or widower with a dependent child.

Some employees may be subject to a lower tax income because they qualify for certain tax benefits. Tax benefits can either be tax credits, tax exemptions, or tax deductions.

Meanwhile, state income taxes also vary. Alaska, Wyoming, Texas, South Dakota, Tennessee, Florida, and Nevada impose zero income taxes. Washington and New Hampshire impose flat tax rates on dividends and interest income only.

Arizona, Utah, Colorado, Illinois, Michigan, Kentucky, Idaho, Indiana, Mississippi, North Carolina, and Pennsylvania impose flat tax rates. The rest of the states have progressive tax rates.

Local income taxes only apply in states where state income taxes are levied.

How to Calculate Income Taxes

To calculate or withhold income taxes, employers must first have employees fill out IRS Form W-4, Employee’s Withholding Certificate. Form W-4 provides all the necessary background about an employee’s financial status and household information.

On the said form, employees specify their civil status, enumerate other income sources they may have, and declare their dependents if there are any.

Employers will then combine all the details on each employee’s W-4, including their tax bracket and filing status, to calculate the correct amount of taxes to withhold from their employee’s earnings.

Here’s an example of using the wage or tax bracket in determining federal income tax:

Based on the tax brackets for the tax year 2023, if an employee is single and earns anything between $44,725 and $95,375, then they owe $5,147 in taxes, plus 22% of the amount exceeding $44,725.

In contrast, if an employee is single and earns less than $11,000, then they are subject to paying 10% of their taxable income.

How Are Income Taxes Used?

Income taxes are used to help finance government programs and activities in general. Examples of these activities and programs include building infrastructure, paying interest on national debts, and providing funding and assistance to veterans and federal civil service retirees.

State and local income taxes fund programs such as health care and education, assisting low-income families, improving corrections facilities, enhancing public safety, and developing more efficient public transit systems.

Income taxes may also contribute to creating recreational facilities such as parks and gyms, handling police force expenditures, preparing and launching campaigns meant to preserve the environment, and generating resources to fund government employees’ salaries.

How Are Payroll Taxes Used?

Between payroll tax vs. income tax, the use of payroll taxes is more specific. These taxes provide the government with a reservoir to consistently assist individuals who were laid off from their jobs but not out of their own volition, usually due to a business closure.

The funds generated through paying payroll taxes also benefit people with disabilities and senior citizens.

Given that employers, employees, and self-employed individuals are mandated to pay payroll taxes, FICA, FUTA, and SUTA taxes combined generate a strong safety net for the federal, state, and local government’s most essential programs.

4 Best Practices for Filing Payroll and Income Taxes

Consistency and accuracy are crucial in filing payroll tax or income tax. Errors in calculating any of these taxes can lead to penalties and even disputes between employers and employees.

Below are four of the best and most effective practices to adopt in filing payroll tax and income tax:

Keep Employee W-4 and Income Information Updated

Employers must make it a point to verify that all the information provided by each employee is up-to-date. At best, review their W-4 forms upon employment to ensure the human resources and payroll departments work with employee information that’s 100% correct.

Otherwise, a single mistake in their filing status or even tax bracket could lead to a series of mistakes in determining their withholding taxes.

Should an employee undergo significant life changes that directly affect their tax and financial status, such as getting married, having kids, or getting a promotion, have them prioritize updating their information.

Use a Pay Stub Generator

While some employers may not have any problem calculating income taxes because they have a relatively smaller workforce, employers with over a hundred employees may need to use online tools to speed up the calculating process.

Pay stub generators come in handy for employers that want to hasten the calculation of payroll tax and income tax for each employee. Pay stub generators come with built-in tax calculators and templates that let employers calculate income taxes with accuracy and speed.

Another advantage of using pay stub generators is that employers, employees, and self-employed individuals can generate PDF or electronic copies of pay stubs. Electronic pay stub copies come in handy when filing tax returns and preparing proof of income.

Follow Tax Deadlines Strictly

Missing tax deadlines means incurring penalties that increase the longer it takes to file and report payroll and income taxes after the deadline.

The tax filing deadline for taxpayers following the calendar year was April 18 of this year. Although the deadline is already over, taxpayers can still file for a tax extension until October 16, 2023.

The tax deadline next year is April 15, 2024.

Fiscal year filers must file their taxes on the 15th of the fourth month following the end of their fiscal year. In case the deadline falls on a holiday or a weekend, the deadline is then moved to the next business day.

Watch Out for IRS Updates

The IRS may make significant changes in terms of the forms used to file tax returns or the percentage of taxes owed on each tax bracket.

One of the most recent changes implemented by the IRS was the resumption of the use of the 1099-NEC form to report nonemployee compensation to freelancers, self-employed individuals, and independent contractors.

By staying informed of the upcoming big and small changes in existing IRS regulations, businesses and employees can avoid paying fees, facing penalties, or even legal action if they fail to abide by any tax rule revisions.

Final Thoughts

Differentiating payroll tax vs. income tax is a basic skill and knowledge that every business owner and employee should possess, especially since both payroll and income taxes aid in improving the quality of life for communities across the U.S.

But both employees and employers should keep in mind that a single mistake in calculating payroll tax or income tax, such as miscalculating the FICA tax percentages or following the wrong tax bracket in determining income taxes, could lead to serious consequences for both.

Payroll Tax vs. Income Tax FAQ

#1. Is payroll tax a flat percentage?

Yes, payroll tax follows a flat percentage. Between payroll tax vs. income tax, payroll tax uses the same tax rates for FICA and FUTA taxes. SUTA may vary depending on the regulations followed by each state on unemployment taxes.

#2. Who pays the most payroll taxes?

Self-employed individuals and employers pay the most payroll taxes because they pay the full 12.4% for Social Security and 2.9% for Medicare taxes. Together, FICA taxes alone comprise 15.3% of a self-employed taxpayer’s income.

Employers may share the Social Security and Medicare taxes with their employees, but they also pay FUTA taxes each year. If they are based in a state that imposes SUTA taxes, then that also means additional expenses to add to their accrued payroll.