The Basics on Payroll Tax

What Is a Payroll Tax?

A payroll tax includes the taxes employees and employers pay on wages, tips, and salaries. For employees, taxes are withheld from their paychecks and paid to the government by the employer. These taxes include federal, state, and local income taxes, and the employee's share of Social Security and Medicare taxes (FICA). Taxes that employers must pay include their share of FICA as well as federal and state unemployment taxes.

Understanding Payroll Taxes

Federal payroll taxes cover Social Security and Medicare contributions, which constitute the Federal Insurance Contributions Act (FICA) tax in the United States. These are labeled as MedFICA and FICA on pay stubs. Federal income tax, which is also 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.

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, healthcare, and workers' compensation. Local governments may collect a small payroll tax to maintain and improve local infrastructure and services, including first responders, road maintenance, and parks.

Tax Amounts

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. An employee pays 7.65% for Medicare and Social Security (6.2% for Social Security and 1.45% for Medicare). An employer also pays the same tax of 7.65% for an employee, for a total of 15.3%.

For Social Security, there is an income cap over which no tax for Social Security is levied. For 2023, the income cap is $160,200, and for 2024, the cap is $168,600, making the FICA portion of the U.S. payroll tax a regressive tax. There is no income limit on Medicare, but anyone who earns more than $200,000 pays another 0.9% for Medicare.

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.

Self-Employment Taxes

Self-employed individuals, including contractors, freelance writers, musicians, and small business owners, must remit payroll taxes, sometimes referred to as self-employment taxes.

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

The self-employment tax rate for 2023 and 2024 is 15.3%, including a 12.4% contribution to Social Security—old-age, survivors, and disability insurance. The other portion of the tax is a 2.9% payment to Medicare, with another 0.9% surtax for Medicare on 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.

The Social Security tax is 6.2%, paid by both the employee and the employer, for a total of 12.4%. Income above $160,200 in 2023 (and $168,600 in 2024) is not taxed for Social Security.

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 receiving Social Security benefits; however, the U.S. Congress replaced the exemption with a cap that usually increases at the same rate as wages.

Medicare Payroll Tax

As noted above, payroll taxes also go toward Medicare. These payroll deductions go into one of two separate trust funds: the Hospital Insurance Trust Fund. The Hospital Insurance Trust Fund pays for Medicare Part A and the associated administration fees. Part A assists in covering hospital care, skilled nursing inpatient care, and, in some cases, home care.

Most people don't pay a premium for Part A (hospital insurance) since they likely paid into the program during their working years through the payroll tax. The tax for Medicare is 1.45% for the employer and 1.45% for the employee, for a total Medicare tax of 2.9%. For individuals that earn over $200,000, an additional 0.9% is charged. This additional tax only applies to the employee, not the employer.

The other Medicare trust fund is the Supplementary Medical Insurance Trust Fund, which assists in paying for Medicare Parts B and D and other Medicare program administration costs. Part B covers laboratory tests and screenings, outpatient care, x-rays, ambulance service, and many additional costs. Part D helps with prescription drugs. This trust fund is funded through the authorization of congress that allocates funds, the premiums from people who are enrolled in Part B and D, and other sources, such as interest earned on the fund's investments.

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.

The Bottom Line

Payroll taxes are the taxes employees and employers pay on wages, tips, and salaries. These taxes include federal, state, and local taxes, as well as FICA taxes, which are taxes for Social Security and Medicare. These taxes are all taken out of an employee's wages.

These taxes are used for wide-ranging areas, including Social Security, healthcare, defense spending, government salaries, and workers' compensation. Local governments may collect a small payroll tax to maintain and improve local infrastructure and services, including first responders, road maintenance, and parks.