Hiring your first employee is exhilarating. It’s also the day you become responsible for payroll tax.
Payroll tax is a blanket term used to refer to all taxes paid on employee’s wages. They include Federal Insurance Contribution Act (FICA) and self-employment taxes. Both of these cover Social Security and Medicare taxes.
As an employer, you’re responsible for deducting part of each employee’s wages to pay specific taxes on their behalf and paying payroll taxes on each of them out of your revenue. Even employees are responsible for paying payroll taxes. However, the amount each pays depends on the tax code.
Employees pay federal and local income taxes, Social Security tax, and Medicare tax. Employers pay Social Security tax and Medicare tax, too, but also pay some taxes employees don’t, like unemployment taxes.
Put simply, payroll taxes are the taxes you pay on the wages and salaries of employees and the reason why employee take-home pay is different from the actual salary.
Why Does Payroll Tax Matter?
The Tax Foundation found that social insurance taxes account for 23.05% of combined federal, state, and local government revenue, making it the second-largest source of government revenue in the United States. This means payroll taxes are a crucial component of America’s taxation system and fill an essential role in keeping social insurance programs funded and operational.
Social insurance programs, particularly Medicare and Social Security, are constantly facing financial crunches. These challenges will become even more intense due to the decline in economic activity and issues brought on by the ongoing Coronavirus pandemic and legislation response.
Payroll taxes help ensure these programs continue providing benefits to those who need them.
What Does Success Look Like?
There are three steps to successfully paying payroll taxes: understanding how the process works, calculating the taxable figures, and submitting taxes to appropriate government authority. Read on as we discuss these steps in more detail.
Knowing How Payroll Taxes Work
Employees and employers pay payroll taxes based on the gross pay every employee receives. Let’s suppose the payroll tax is 5%. If an employee receives $1000, their net income will reduce to $950 after deducting the 5% tax.
Every employee can see their payroll deductions on their pay stubs, as well as their number of hours worked and hourly rate. Pay stubs should clearly outline each deduction, including Medicare, Social Security, federal, and state income taxes.
After those, the employer deducts non-tax items from every employee’s paychecks, such as 401(k) contributions, medical insurance, and so on. After removing all deductions, the worker receives the net amount in their paycheck.
The government usually bases payroll taxes on the gross amount earned by the worker. However, most payroll taxes don’t adjust for deductions, nor do the employers’ payroll taxes appear on the employees’ paychecks. The latter is based on the size of their workers’ paychecks.
Calculating Payroll Taxes Accurately
Calculating payroll taxes can be relatively straightforward.
We know employees and employers pay these taxes based on gross pay. Next, you have to figure out the tax rate for each payroll tax that every employee must pay and multiply it by the employees‘ gross income.
Let’s explain this with the help of an example:
Suppose John in Florida earns $1,000 per paycheck and must pay 6.2% in Social Security taxes and 1.45% in Medicare taxes. This means his total liability is: [$1,000 x 6.2% = $62] + [$1,000 x 1.45% = $15] = $76.50.
Then state and local taxes are taken out. If the federal income tax is 9.28% ($93) and there are no additional Florida state income taxes, John will take home $831 per paycheck. This number does not account for any deductions for 401(k) or insurance benefits.
Employers have to pay an equal amount in Social Security and Medicare taxes, meaning the company that employs John will also pay the same amount, in this case, $76.50. Additionally, the company will calculate the unemployment tax based on John’s $1,000 gross pay.
Submitting Payroll Taxes
While you don’t need any particular forms to calculate and deposit payroll taxes, you’ll have to file some important forms to report them.
After calculating your taxes, you must deposit payroll taxes electronically through the federal electronic tax payment system (EFTPS). This is perfect for small employers, who can pay their employment tax when filing their annual employment tax returns. For state employment taxes, though, it’s better to check with your state to understand how to deposit employment taxes.
You must take payroll taxes seriously. While the IRS is more than accommodating for honest mistakes, they are also quick to punish those trying to dodge their tax responsibilities. Think heavy penalties, permanent business shutdown, and even prison time!
Here is an example of those consequences:
Alphonso Tillman was the president and sole owner of two companies that provided security guards to protect commercial and residential properties. He didn’t file the required forms or pay payroll taxes due, despite both companies withholding taxes from employee’s paychecks. The only time he did pay up was from the IRS’s collection efforts.
Tillman was sentenced to 24 months in prison and three years of supervised release in January 2013 for failing to account for and pay employment taxes. He was also ordered to pay restitution of $2,205,991.
Payroll taxes are the government’s money. When you don’t pay them, you’re stealing from the government, making authorities aggressive in assessing the penalty.
One Secret Weapon for Calculating Payroll Taxes
Having a detailed breakdown of every employee’s pay is one of the main foundations of payroll taxes. This way, both the employee and the employer have all the necessary information to calculate gross pay and make deductions to know the net pay.
Payroll services can be a solid weapon to organize and store information and calculate your payroll tax liability. One of our favorite services is Gusto.
Gusto is a full-service payroll tool and takes care of everything to help you run a business. The service offers customized hiring and onboarding features, along with an e-sign facility to make recruitment a breeze. Its time tracking and the employee benefits program will make sure your employees don’t have any problem with payroll, considerably improving employee retention.
One of the main reasons we like Gusto is that it’s full of payroll options. It supports hourly and salaried employees and lets you run payroll in all 50 states. For payroll taxes, in particular, Gusto has a free Employer Tax Calculator to give you a clearer picture of all your payroll taxes whenever you bring in a new employee.
5 Essential Strategies for Payroll Taxes
Let’s take a look at five strategies to help you go about payroll taxes and stay in the good books of the IRS.
Understand Your Payroll Responsibilities
As an employer, you have several monetary when it comes to handling taxes. You must know each one of them if you want to do your job correctly.
- Figure out your income tax withholding and other employment taxes.
- Deposit all employment taxes according to a set deposit schedule (there’s an exception for very small employers).
- Report every quarter about your employment taxes covering income tax withholding and FICA.
- Send annual reports to employees and the Social Security administration about employee tax payments is also important.
- Stay on top of annual FUTA reporting, as well as state-level reporting.
You may have to withhold other amounts from your employees’ paychecks, including salary elective deferral amounts for employee contributions or garnishment to cover child support. Keep in mind that these additional amounts do NOT come into employment taxes.
Know the Latest Payroll Tax Rates
You must consider several variables to calculate the payroll tax rate.
Refer to IRS’s Publication 15 (Circular E) – The Employer’s Tax Guide. Since this is updated yearly, you’ll always have access to the latest withholding tables and tax rates for federal income tax, FICA taxes, and FUTA.
Here’s a general overview of how payroll taxes work:
- For Medicare, the employer and the employee each contribute 1.45%, making the total 2.9%. But that’s not it; employees who earn over $200,000 pay an additional 0.9%. Employers, however, are not responsible for contributing any extra amount for such employees.
- For Social Security, the employer and employee each contribute 6.2%, making the total 12.4% to a maximum taxable earnings amount of $137,700.
- FUTA is set at 6%, with maximum taxable earnings of $7,000. However, if an employer pays their SUTA tax on time, they can receive up to a 5.4% reduction, making the rate 0.6%.
- Every individual state sets state income tax and SUTA rates.
- For local taxes, each tax is unique to each locality. Be sure to find out more information about these taxes and learn how they affect your business and payroll.
The good news is the IRS and other tax authorities give you statements showing which rates apply to your business and what payment and reporting schedules you should follow when registering your business. If you’re still unsure, you can call the appropriate tax authority or work with the professional bookkeeper, accountant, or tax professional to determine the right amount and reporting frequencies.
Find Out Payroll Tax Payment Deadlines
Taxes aren’t a one-time affair once you start running a business. Depending on your business mission size, you’ll have to deposit tax payments to the IRS either monthly or semi-weekly. Filing quarterly tax returns and providing other documentation as required by the IRS deadlines is also there.
State tax payment deadlines often follow the IRS’s schedule, but it’s better to double-check with your state taxation authorities to be on the safer side.
Figure Out the Best Way to Manage Your Taxes
There are various ways to manage employee payroll taxes and ensuring your business complies with the IRS. You can select a method based on what you prefer best.
- Take Matters in Your Own Hands. Take the responsibility of completing taxes for each employee in your company yourself. Analyze every employee’s W-4 tax form, calculate allowances, refer to income tables, and do some basic maths to withhold the right amount of money. Don’t forget to calculate state and federal payroll tax withholdings too.
- Hire a Tax Professional. Tax professionals come with experience and expertise. As they guide you through every step of calculating and submitting payroll taxes, the possibility of making errors is greatly minimized.
- Get a Payroll Service. Payroll services are third-party payroll processing companies that effectively manage employee payroll and come packed with several useful features, such as tax compliance and payroll processing. While you can always opt for our top recommendation, Gusto, several other solutions have specific features to simplify payroll taxes.
Take Advantage of Available Tools
Every business owner needs some kind of support to ensure they are fully compliant with payroll tax policies because of the ever-changing thresholds and percentages. Luckily, some tools and individuals can assist you with continued knowledge building and information gathering.
- Payroll tax calculators—just like Gusto’s that we mentioned above. Make sure you use one that’s up-to-date to avoid miscalculations.
- Downloadable IRS guides outline every aspect related to payroll.
- Consulting with professionals and experts on the subject.
Most Common Mistakes of Payroll Taxes
Here is how to avoid some of the most common mistakes made by business owners when it comes to payroll taxes:
- Double-check employee identification numbers (EIN). A typo in EINs can mess up your efforts. The ID numbers may be temporary if they’re issued during the application process. This can be an issue if you operate in a state that requires a permanent ID number.
- Avoid repetitive mistakes. If you repeatedly miss your payment and reporting deadlines, underreport liabilities, or use the wrong tax tables, you might end up getting penalized. Make sure you find out the deadline schedule and are extremely thorough when calculating your taxes. Remember, tax authorities may let you off easy initially, but they’ll get increasingly aggressive every time you make a similar error.
- Classify your employees correctly. Employees are treated differently than freelancers and contractors when it comes to taxes. If you misclassify them, you’ll end up becoming liable for all the back taxes. If you need any motivation to avoid this mistake, just take a look at Uber’s $100-million lawsuit.
Payroll taxes are overwhelming. With payroll tax rules constantly changing, new laws coming into effect, and several other things, staying on top of things can be challenging. Your best bet is to use a payroll service provider to help you do things correctly and on time. Then you’ll have peace of mind and stay on the right side of the law.