Payroll Taxes

Payroll taxes are the federal and state taxes imposed on wages and administered through an employer's payroll. The Internal Revenue Service uses the term employment taxes and describes them this way: "Employers must deposit and report federal employment taxes. Some of these taxes are paid by both the employer and the employee, while others are paid by the employer. Examples include federal income tax, Social Security tax, Medicare tax and federal unemployment tax."

Two structural facts distinguish payroll taxes from income tax. They are charged on wages rather than on total income, so deductions, credits and filing status generally do not reduce them. And a substantial share of the cost is legally the employer's, which means the amount deducted from a paycheque is not the whole of what the government collects on that job.

The term has two defensible scopes, and the page cannot honestly pick one. The IRS's employment taxes list includes federal income tax withholding alongside the social-insurance taxes, because from an employer's point of view all of them are collected, deposited and reported through the same process on the same forms. Congressional analysts use "payroll taxes" more narrowly, to mean the dedicated taxes that fund Social Security and Medicare, because those are the ones with their own trust funds and their own benefit entitlements attached. Both usages are current and neither is a mistake. A reader comparing a paystub with a policy article is reading two different definitions of the same phrase, which is worth knowing before trying to reconcile the numbers.

What is actually charged on a paycheque.

Federal unemployment tax is the one nobody sees. Section 3301 imposes it at 6 percent of wages, and section 3306(b)(1) limits it to the first $7,000 paid to each employee in a year. Employers who pay their state unemployment contributions in full and on time receive a credit of up to 5.4 percent, which brings the usual effective rate to 0.6 percent. Two things follow. The tax is entirely the employer's, so it appears on no paystub and no Form W-2. And the $7,000 base has not moved since 1982 and is not indexed, so what was once a meaningful charge is now a small fixed cost per employee rather than a proportional one.

The withholding trigger for the Additional Medicare Tax does not match the liability. Section 3102(f)(1) requires an employer to withhold the 0.9 percent only on wages above $200,000 paid by that employer, and expressly permits the employer to disregard a spouse's wages. The tax itself is owed above $250,000 on a joint return. So a married couple each earning $150,000 have $300,000 of combined wages and owe the tax, while neither employer withholds a cent of it, and the shortfall surfaces at filing. Both figures are statutory and neither is indexed.

Withheld amounts are trust money, and that changes who is exposed. Section 7501 provides that tax collected or withheld from another person "shall be held to be a special fund in trust for the United States". Section 6672 then imposes a penalty equal to the entire unpaid amount on any person required to collect, account for and pay over the tax who wilfully fails to do so. That reaches an individual personally, which is why unpaid withholding is one of the few business liabilities that a limited liability entity does not shield its owners and officers from.

Two symmetrical misunderstandings. Not everything withheld from pay is a tax: health insurance premiums, retirement plan contributions, union dues and garnishments all reduce a paycheque and none of them is a payroll tax. And not every payroll tax is withheld: the employer's matching share, federal unemployment tax and state unemployment insurance are all real costs of employing someone that never appear on the employee's paystub, which is why the cost of a job to an employer exceeds the gross pay on the offer letter.

For an employee the sequence is invisible but fixed, and it runs every pay period.

1. Gross wages are computed, and any pre-tax deductions such as certain health premiums or traditional retirement deferrals are subtracted first, which is why the wage figure the taxes apply to is often smaller than gross pay.

2. The social-insurance taxes are withheld at their flat rates, with the Social Security portion stopping once the annual wage base is reached and the Medicare portion continuing indefinitely.

3. Federal income tax is withheld according to the employee's Form W-4, and state income tax where applicable.

4. The employer adds its own share of the social-insurance taxes and its unemployment taxes, which are not deducted from the employee.

5. The employer deposits everything and reports it, generally on Form 941 each quarter and Form 940 annually for federal unemployment tax, and issues a Form W-2 to the employee after year end.

A hypothetical example of the gap between what an employee sees and what a job costs. Bea earns $5,000 in a month. Her employer withholds the social-insurance taxes at the combined employee rate of 7.65 percent, which is $382.50, plus income tax under her Form W-4. Her employer then pays a matching $382.50 that never appears on her paystub, and separately owes federal and state unemployment tax on her wages. The withheld $382.50 is Bea's; the matching $382.50 is a cost of employing her; and both are collected and deposited by the same employer in the same transaction.

What the system does well

• Collection is automatic and continuous, so most workers never have to set money aside for these taxes or file anything to pay them.
• The taxes are earmarked, and paying them is what builds an individual Social Security and Medicare record rather than simply funding a budget.
• Flat rates on wages make the amount predictable in a way graduated income tax is not.
• Because the employer deposits and reports everything, an employee needs no records and files nothing to have these taxes paid correctly.

Limits and cautions

• The social-insurance taxes apply from the first dollar of wages with no standard deduction equivalent, so they fall hardest as a share of income on the lowest earners.
• Because half the cost is nominally the employer's, the true tax on a job is routinely understated by workers looking only at a paystub.
• The Social Security wage base means the combined rate falls once a high earner passes it, which is the opposite of how income tax behaves.
• Withholding for the Additional Medicare Tax is keyed to a single employer's wages, so a two-earner household can owe it with nothing withheld.
• Unpaid withheld tax is trust money, and the penalty for failing to pay it over reaches responsible individuals personally.