Payroll Tax: Definition, Examples, and Costs Explained

Expanding your workforce requires a hard look at employee hiring costs, including salary, benefits, and payroll tax. In this guide, we explore the payroll tax definition and the costs involved so you can better understand how it impacts your company.

Disclaimer: This article includes information on payroll tax in relation to US laws and is not considered legal or tax advice. Costs and rates are valid at the time of publication.

What is payroll tax?

Payroll tax is a type of tax deducted from an employee’s paycheck. Some payroll taxes are withheld from the employee's pay, some are covered by the employer, and some are split 50/50.

Governments use payroll taxes to help cover the costs of various public programs, including Social Security and Medicare. Local governments tend to use payroll taxes for specific purposes, such as public transportation or infrastructure repairs. Some programs help to ensure people have a living wage when they retire.

Payroll tax examples

In the US, payroll tax examples include:

• Social Security taxes, including both employer and employee portions of Social Security tax amounts due
• Medicare taxes that are withheld from employees’ paychecks
• Unemployment insurance tax on the employer’s contribution rate for employees in most states, as well as unemployment compensation contributions
• State unemployment insurance tax on the employer’s contribution rate for employees in most states. This is usually based on hours worked by each employee or their earnings within a certain time period
• Federal Unemployment Tax Act (FUTA) taxes are paid to the federal government. Some employers receive an offset credit for state unemployment taxes paid. 
• Workers’ compensation insurance premiums, which cover work injuries or illnesses that occur while employees are on the job. Employers in most US states must carry this insurance for their workers
• Income tax withholding on wages and salaries paid to employees

Payroll taxes vary from one country to another. In the United Kingdom, payroll taxes are levied on employees’ wages to finance their social security programs. These can include Pay As You Earn (PAYE) income tax and Employees’ National Insurance contributions.

How do you calculate and pay payroll tax?

Employers typically track the amount of tax they withhold from an employee’s pay and then report this information to their state agency, which calculates any additional employer payroll taxes owed.

Employers must withhold income taxes from employees’ earnings unless they certify their exemption under their country’s specific tax regulations. The state may also require you to withhold personal income taxes from wages.

To calculate the accurate amount of tax to withhold from the employee’s salary, employers need Form W-4, which employees are expected to complete and submit. Employers must also provide employees with IRS Form W-2, an annual report that states the employee’s earned wages and withheld taxes. Most employers are also required to include payroll tax calculations on employee pay stubs.

The Internal Revenue Service (IRS) requires employers to file additional forms with their annual tax returns to report the amounts they withheld from employee wages. Employers must also report the employer portion of Federal Insurance Contributions Act (FICA) taxes and any other payroll-related items that apply to them.

What do employers pay in payroll taxes?

Payroll tax rates and responsibilities are determined by local laws and vary by country. In some countries, they also vary by state or region. In the US, employers pay four federal payroll taxes: Social Security, Medicare, unemployment tax, and income tax. In some cases, employees and employers split the cost.

Social Security

FICA mandates the employer and employee contribute to the Medicare and Social Security programs. The Social Security portion of FICA taxes requires a 12.4% deduction on employee earnings, per the IRS limits. Employers pay half (6.2%), and the employee pays the other half.

Medicare

Medicare costs 2.9% of your employee earnings. Half the earnings come from the employer and the other half from employees. However, the rate for employee payroll taxes tends to increase by 0.9% when their earnings pass the annual $200,000 (USD). 

There may be additional Medicare tax depending on your wage base, earned income, and type of insurance policy.

Unemployment tax

For unemployment tax, employers pay up to 6% on the first $7,000 the employee earns. Ultimately, the employer pays for everything here. If you pay your taxes on time, the rate can drop to as low as 0.6%.

Income tax

Income tax can be paid entirely from an employee’s wages, but the rate changes depending on how much they earn. Plus, you might want to claim allowances for them which helps to lower the tax bill even more. Ultimately, the more allowances employees claim, the less money the employer has to pay in payroll taxes at the end of the year.

Deductions

Employers may deduct expenses (such as a uniform or work tools) from an employee’s paycheck, so long as it doesn’t result in the employee’s pay dipping below minimum wage. In some cases, there may be deductions made from an employee’s earnings if they have been late for their shift, didn’t come at all, or took time off without permission.

Tax credits

You may get a tax credit depending on the tax year, organization, or if you’re a self-employed business owner. Some countries may exempt you from tax payments if you operate a nonprofit. Old age might also determine how much tax credit you’re entitled to per year. People eligible for disability insurance may also be exempted from state payroll taxes. Taxpayers can also request a child tax credit.

Frequently asked questions about payroll tax

What’s the difference between payroll tax and income tax?

The difference between payroll tax and income tax comes down to who is responsible for paying the tax and what it funds.

Payroll taxes are the responsibility of the employer, though some contributions are split with the employee. Payroll tax typically goes toward social insurance programs such as Social Security and Medicare, but this depends on the level of government (state vs. federal).

Income tax is tax paid on the amount of money you earn per year and is the responsibility of the employee. It typically goes toward government spending and public services.

What is payroll withholding?

Payroll withholding is when a portion of an employee’s income is held back from their gross pay by their employer for tax purposes. It’s also known as payroll tax withholding.

Payroll withholding occurs before the employee receives their paycheck. The withheld amount is based on the employee’s income and local income tax laws. The withheld funds are paid to local governments and agencies, such as the IRS.

When are employer payroll taxes due?

As an employer, you must withhold payroll taxes when paying your employees every tax year. Usually, the tax is withheld from their regular paycheck and paid to the relevant authorities monthly or biweekly. Learn more about employment tax due dates.

Who pays payroll tax (employee vs. contractor)?

If you’re employed by someone else, it’s their responsibility to cover the payroll tax. On the other hand, independent contractors must take care of Social Security benefits independently and cover the self-employment tax.

Depending on the employer-worker relationship, scope of work, and other factors, an independent contractor may be considered an employee and subject to different employment laws.

How can I reduce payroll taxes?

There are several ways to reduce the amount of money your business pays in tax obligations:

• Make sure you file and pay all estimated quarterly payments on time. Failing to do so could result in a penalty and interest charges
• File your tax returns even if you don’t owe any taxes. Failing to file can result in penalties and fines. Some states charge their filing fees, while others impose additional penalties for late payments or nonpayment of tax obligations
• Save receipts and invoices for all business expenses you incur conducting your company’s operations. This can include items like office supplies, equipment purchases, and employee compensation
• Keep detailed records of each deduction made on an employee’s paycheck to ensure they’re not overpaying on their taxes and to ensure you’re not making errors. Also, make sure employees know their taxable wages
• Keep accurate records of all income generated from operations. Also, record any outflow costs that may have been deducted from an employee’s paycheck or elsewhere to avoid overpaying payroll taxes or filing inaccurate tax reports
• Make use of tax deductions and other financial incentives or programs your business may qualify for. These can include federal, state, and local government credits as well as employer-sponsored retirement plans like 401(k)s (which allow you to defer income until later in life), health insurance benefits through the Small -- Business Health Options Program (SHOP) Marketplace, and more
• Consider hiring an accounting firm to help you with your bookkeeping, filing, and other tax-related obligations

Eliminate ongoing payroll admin with Deel

With Deel, you can fund payroll across the world with just a click and automatically calculate taxes without lifting a finger. Our multiple currency options and various withdrawal methods make it even easier for your team to get paid on time every time.

How does Deel compare to other payroll providers? With our team, you benefit from:

• Global coverage for hiring and paying direct employees, EOR employees, and independent contractors
• 68+ integrations with your favorite accounting tools
• 24/7 support plus a dedicated account manager for your team
• 8 withdrawal options for contractor payments
• Advanced payments
• Off-cycle payments
• In-house legal experts to ensure compliance wherever your hire
• Global Payroll, US payroll, contractor management, EOR, HR, and more—all in one platform

Sound like something your business could use? Learn more about Global Payroll, Deel US Payroll, or book a product demo with an expert to see Deel in action.