A Guide to Understanding Employment Taxes
Updated: Mar 29
Running a business is already challenging enough. The last thing you need is more complicated tax jargon coming from the IRS. If you are an employer, the IRS not only expects you to pay your business taxes, but you will also be responsible for withholding the correct taxes for your employees. We have put together a little guide to help explain the different types of employment taxes and how to navigate them.
What Classifies as Employment Taxes?
Employment taxes, as described by the IRS, are the taxes that you, your business, and your employees must pay to federal agencies. Self-employment tax, Social Security, Medicare, FICA, as well as federal, state, and local taxes are employment taxes that the employee and employer contribute to. Employers are also responsible for paying unemployment taxes and workers compensation. Employees do not have to contribute to these. It is crucial that business owners know and understand the different employment taxes or else they risk being audited by the IRS.
Payroll taxes are taxes imposed on employees or employers based on a percentage of employee wages. Payroll taxes generally can be broken up into two categories: deductions from an employee’s wages or taxes paid by the employer based on the employee’s wages. Payroll taxes are the employer’s responsibility and penalties can be given by the IRS if not done properly. Regardless of the type of payroll tax, it is the employer’s obligation to deposit them.
Federal Income Tax
Employers must withhold federal income tax from their employees’ wages. Each employee will have a different income tax rate depending on their earnings. The income tax withholdings from employee’s paychecks are designed to cover their federal tax bill. Keep in mind that these withholdings are only for the wages earned at that specific company. For example, if an employee makes a salary but also has other sources of income outside of their job, the employer will only be responsible for withholding wages specifically from that job.
Each state has different tax rates, and it can get confusing especially for people who work across state lines. States like Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming have no income tax. Other states such as New Hampshire and Tennessee do not tax wages but require employers to withhold state income tax from employees’ paychecks. Some localities and cities such as New York City and Philadelphia have city taxes which require additional withholdings. It’s critical to keep track of where employees are working and the different rates from state to state. Failure to accurately record the correct tax rate can lead to fines from the IRS.
Social Security & Medicare Tax (FICA)
All employers in the U.S. must deduct FICA taxes from their employees’ paychecks in order to fund Social Security and Medicare. The social security tax accounts for 12.4% of gross pay split evenly between the employer and the employee. This means that the employee’s Social Security deduction is 6.2% of gross pay. Likewise, the employer also contributes 6.2% of gross pay. The Social Security maximum taxable income for 2021 is $142,800 a year.
The Medicare portion of FICA taxes are also evenly split between employer and employee for a total of 2.9% of gross wages. This means that the employee’s deduction for Medicare taxes is 1.45% of gross pay. The employer must contribute 1.45% of the gross wages too. However, unlike Social Security, Medicare taxes have no maximum wage. In fact, there is an additional Medicare tax for individuals whose annual income is greater than $200,000. The additional tax amount is 0.9% of the employee’s gross income. For married couples who file jointly, the additional Medicare tax kicks in at $250,000 in annual income, rather than the $200,000 for individuals.
Federal and State Unemployment Taxes
Employers are required to pay the federal unemployment tax (FUTA). Employees do not have to contribute to this tax. The FUTA tax pays for nationwide unemployment benefits. Employers contribute based on the gross earnings of their employees. The tax only applies to the first $7,000 of wages for each employee. The standard FUTA rate is 6% but employers can receive credit up to 5.4% depending on their state unemployment tax rate. If an employer were to get the maximum credit of 5.4%, that means the effective tax rate for FUTA would be 0.6%, or $42 per employee.
States also fund unemployment benefits and impose a state unemployment tax (SUTA) on employers. This tax is slightly different from the FUTA. The state tax is more like insurance because the rate is variable depending on the employer’s claims experience. The more claims made by former workers, the higher the tax rate on such employees. Each year the state will assign the employer their tax rate, which can never be below a minimum amount.
The self-employment tax, sometimes called the SECA tax, is a social security and Medicare tax for people who work for themselves. These taxes are not withheld so the owner must make sure they are saving enough for tax season. The tax is calculated on the net income of the business and paid on the owner’s personal tax return. The total tax rate is 15.3%. For those making more than $200,000 for the year as an individual, or $250,000 as a married couple, you will also have to pay the additional Medicare tax at 0.9%. Thankfully, the IRS allowed self-employed people to deduct the employer half of the self-employed tax on your tax return. In order to qualify for this deduction, you will need to complete a Schedule SE.
In conclusion, employment taxes may seem daunting and confusing. The rules are continuously changing and are different from state to state and even city to city. Partnering with a PEO like CornerstonePEO may be in your best interest. CornerstonePEO covers everything from HR and employee benefits to payroll and workers comp. Our industry leading PEO services offer innovative, cost effective, easy to understand business solutions for companies of any size and industry. Contact us to learn more.