Updated July 10, 2023
Definition of Payroll Tax
The employer deducts Payroll Tax from the employee’s salary and pays it on behalf of the employee to the government. The government determines the tax based on each employee’s income, which varies between employees and includes deductions permitted by the government.
The employee contributes a portion, while the employer covers the remaining part. The federal government and certain states impose these taxes on employees’ income to finance income tax withholding, social security schemes, healthcare, and other social security initiatives.
The employer pays employees wages and salaries as part of their employment contract. Before paying the salaries and wages, the employer deducts payroll tax based on the employee’s total earnings after deducting a certain deduction to which the employee is eligible. Also, It comprises the employer’s contributions as well. The employer must file the deducted payroll tax return and disclose it in its Financial Reporting.
It comprises Federal income tax, Social security tax, Medicare Tax, State Income Tax, and various local taxes, which vary from state to state.
How to Calculate Payroll Tax?
The computation of Payroll Tax involves multiple steps, as follows:
- Step 1 involves the employer obtaining the employer’s identification number and getting employee’s identification number.
- Step 2 involves determining the state where the employee will be assigned. This is to determine the state deduction liability.
- Step 3 involves determining the total income of the employee (Gross Pay)
- Step 4 involves making applicable deductions in the form of Federal income tax, social security tax, and Medicare Tax.
- Step 5 involves contributing to the employer’s contribution of the above deductions.
- Step 6 involves making any other deduction, including State Income Tax deduction as determined in Step 2, if applicable.
- Step 7 includes timely filing of the same with the Federal and state governments per the timelines to avoid penalties.
The above steps are indicative; actual steps can be merged or skipped depending on case to case; however, the broad structure of activities involved remains the same.
Example of Payroll Tax
Mr. A is employed with XYZ International Limited, registered with the federal government of the USA, and is eligible for collecting Payroll tax on behalf of its employees. The company is located in Texas, where State Income Tax is exempted.
Below are the details of the Income of Mr. A based on which applicable Payroll tax deductions have been undertaken:
Employee Contribution to working
|Particulars||Amount in USD|
|Old age and survivor Insurance (Federal Deduction 6.2% each both by employer and employee)||$12,400|
|Disability Insurance (Federal Deduction 0.9% each both by employer and employee)||$1,800|
|Medicare Deduction (Federal Deduction 1.45% each both by employer and employee)||$2,900|
|Unemployment insurance (Federal Deduction 0.6% by the employer only)||$0|
|Total Payroll Tax||$17,100|
Components of Payroll Tax
It comprises the following components:
- Federal Income Tax: This is withheld and forms a revenue source for the Federal government
- Social Security Tax: This payroll tax component forms part of old age and unemployment benefits extended by the Federal government. It is contributed equally by employer and employee at 6.2% each beyond a threshold income limit which may vary yearly.
- Medicare Tax: This Payroll tax component forms part of federal government schemes comprising health care benefits to senior citizens. It is contributed equally by employer and employee at 1.45% each and applies to employees at all levels without any threshold income limit.
- Additional Medicare Tax for those employees earning more than a stipulated limit varies from year to year.
- State Income Tax: This component is deducted from the employee’s income and paid to the state authority. The percentage deduction varies from state to state in the USA, with some states not levying this deduction, such as Texas.
- Any other local tax withholding specific to a particular state. Together all these components form the Payroll Tax.
The responsibility and ownership of collecting and filing Payroll Taxes lie on the employer and not the employee. For this purpose, the company must register itself under Payroll Tax based on the state in which it is incorporated in the United States of America.
After that, the company will receive a unique number known as an Employer Identification Number (EIN). Based on the state of incorporation, the company must comply with Federal and State payroll tax laws.
- Very good government tax revenue source and forms a good percentage of total tax collection.
- Stable source of revenue and doesn’t vary much, as employment and payroll don’t change frequently.
- Hard to evade by the individual and leads to less income leakage for the government.
It is a significant source of revenue for the government. This tax revenue serves many purposes of the government and helps them provide social security schemes and Medicare benefits to its people. However, its threshold limit varies from state to state and country to country. Critics often argue that Payroll tax places a heavy burden on employees, reducing their income and resulting in lower disposable income due to the real contribution being deducted from their salary or paid by the employer as part of their contribution to social security schemes and Medicare.
This is a guide to Payroll Tax. Here we also discuss the definition and how to calculate payroll tax. Along with advantages and disadvantages. You may also have a look at the following articles to learn more –