Payroll refers to the total wages a business pays its employees for a specific period or on a predetermined date. It's typically managed by the accounting or human resources departments, though the owner or an associate may handle it in small companies.

Recently, there's been a trend toward outsourcing payroll to specialized firms. These firms handle tasks like paycheck processing, employee benefits, insurance, and tax withholdings. Fintech companies such as Bitwage, Atomic, Pinwheel, Finch, and Wagestream use technology to streamline payroll processes, offering quick, convenient payment methods and digital documentation, catering to the needs of the gig and outsourcing economy.

What is Payroll Tax?

Payroll tax is a fundamental aspect of both employee earnings and employer expenses. Based on employee wages, both parties pay these taxes. Payroll taxes directly affect employees' net salary, reducing their take-home pay. For employers, these taxes add to the cost of employing staff, influencing hiring and compensation plans.

What Comes In Payroll Taxes?

Social Security Taxes

Social Security taxes, a crucial part of payroll taxes, take 6.2% of an employee's income and match employer contributions. Social Security does not tax income over $160,200 in 2023. Regression occurs when high-earners contribute less than low-earners.

Imagine a $120,000-a-year worker. They contribute 6.2% total. In contrast, someone earning $200,000 pays the same tax rate up to $160,200. The effective Social Security tax rate for high earners decreases. This aspect of Social Security taxes has sparked discussions around its fairness and the future financial health of the Social Security fund.

Medicare Taxes

Integrating into employer payroll taxes, Medicare taxes stand at a flat rate of 1.45% for both employees and employers. Those earning above $200,000 incur an additional Medicare tax of 0.9%, exclusive to the employee. This extra levy does not require a corresponding employer contribution.

The purpose of this additional tax is to support the Medicare program, which offers healthcare to seniors and disabled individuals. As healthcare expenses rise, this tax is crucial in ensuring the program's viability, helping it meet growing demands and escalating costs.

Federal and State Unemployment Taxes

Employers are responsible for federal and state unemployment taxes, distinct components of employer payroll taxes. These taxes fund unemployment benefits, providing financial assistance to individuals who lose their jobs. The tax rate varies depending on the employer's location and industry, reflecting the differing unemployment insurance costs across sectors and regions.

For example, industries with frequent job turnover may face higher unemployment tax rates. This differential approach helps distribute the cost of unemployment insurance more equitably among various business types.

Additional Local Payroll Taxes

Certain local governments impose additional payroll taxes to finance community services and infrastructure projects. These taxes fund public transport, road upkeep, and public safety programs.

Although typically a tiny fraction of an employee’s income, they are vital for local authorities, enabling them to sustain and enhance crucial services and infrastructure within their communities.

Calculating Employee Gross Pay

Calculating payroll taxes begins with understanding an employee's gross pay. This is the total amount earned before any deductions are made. The calculation method depends on whether the employee is paid hourly or has a fixed salary.

Hourly Employees

Gross Pay=Hourly Rate×Total Hours Worked in the Pay Period

Multiple the number of hours worked in the pay period by the hourly rate to calculate gross pay for hourly workers.

Example: An employee earning $20 per hour and working 40 hours per week.

Gross Pay=$20/ℎ×40ℎ=$800

Gross Pay=$20/hour×40hours=$800

Salaried Employees

Gross Pay=Annual Salary​ / Number of Pay Periods in a Year

Salary employees may calculate their gross compensation for each pay period by dividing their yearly salary by the total number of periods of pay in the fiscal year.

Example: an employee with a yearly salary of $52,000 paid bi-weekly (26 pay periods) would have a gross pay of $2,000 per pay period ($52,000 / 26).

Gross Pay=$52,000 / 26=$2,000

Gross Pay=26$52,000​=$2,000

Pre-Tax Deductions

After calculating gross pay, subtract pre-tax deductions. Taxable income can be reduced by 401(k), health insurance, and HSA/FSA contributions. A $200 401(k) contribution and $100 health insurance payment deduct $300 from gross pay before taxes.

Deducting Taxes

After pre-tax deductions, FICA (Social Security and Medicare taxes), unemployment, and income taxes apply to the remaining salary. Employers match the FICA tax contribution, doubling the total contribution to these funds. For example, on a $2,000 gross pay, a 7.65% FICA contribution equals $153 from the employee and employer, totaling $306.

Income tax withholding is determined by the employee's W-4 and applicable tax rates. Tools like the IRS's Income Withholding Assistant help employers calculate the correct withholding amount.

Voluntary Deductions

Net Pay=Taxable Income−Total Taxes Withheld−Voluntary Deductions

After calculating taxes, employers may need to deduct other voluntary items from the employee's pay. These could include additional retirement plan contributions (like a Roth 401, life insurance premiums, long-term disability insurance, union dues, or wage garnishments. These deductions are made post-tax and will affect the employee's net pay.

Example: A worker with $1,700 taxable income would have $200 withheld for taxes and $100 voluntarily.

Net Pay=$1,700−$200−$100=$1,400Net Pay=$1,700−$200−$100=$1,400

Payroll Taxes vs. Income Taxes

When discussing payroll and income taxes, their roles must be distinguished. Social Security and Medicare payroll tax are deducted from an employee's salary and matched by the employer.

These taxes are fixed percentages of an employee's income up to a limit. Progressive income taxes fund a variety of government activities and increase employee income.

Payroll taxes fund social welfare programs, while income taxes fund infrastructure and defense. This distinction emphasizes payroll taxes' targeted support of essential social services.

Bottom Line

Our financial system relies on payroll taxes, affecting employers and employees. These taxes are mandatory deductions for employees and essential hiring costs for employers.

Social Security and Medicare depend on payroll tax. Understanding these taxes' calculation, payment, and purpose is essential for financial planning and compliance for businesses and workers. Payroll taxes benefit individuals and the nation's economy, highlighting their importance in the economic framework.