What is the Difference Between Payroll and Income Taxes?

People often conflate payroll and income taxes because employers withhold both of them from their employees’ paychecks. However, there are notable differences between the two payroll deductions that you should understand for tax planning purposes.

In simple terms, the payroll tax is a flat tax on employee wages that both employers and employees have to pay. 

Meanwhile, the income tax is a progressive tax on all earnings, and only the earner is responsible for paying it.

Let’s take a closer look at how these taxes work, the differences between them, and their impact on employers and employees.

What is Payroll Tax?

The payroll tax includes the Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and State Unemployment Tax Act (SUTA) taxes. Surprisingly, it’s more burdensome for most Americans than the individual income tax.

The payroll tax applies to gross pay from employment, including salaries, bonuses, and tips. It’s a flat tax, which means the rate is the same at all applicable income ranges. There are caveats to that, but we’ll discuss them in the next section.

The FICA tax includes Social Security and Medicare taxes. While it applies to employee earnings, employers are responsible for paying half of the burden.

Note that FICA taxes are essentially the same as the self-employment tax. However, self-employed people are both employers and employees, which means they have to pay both roles’ liabilities.

FUTA and SUTA taxes apply to employee wages also, but are primarily an employer payroll tax. Employees typically aren’t responsible for paying them, as they help fund unemployment insurance for employees.

How is Payroll Tax Calculated?

The FICA tax equals 15.3% of wages, bonuses, and tips. 12.4% goes to the Social Security Administration, and 2.9% is for Medicare. Employers and employees split FICA equally, so each pays 6.2% to Social Security and 1.45% to Medicare, or 7.65% in total.

The FUTA tax is 6% of the first $7,000 of compensation for each employee. However, employers get a 5.4% tax credit as long as they pay their requisite SUTA taxes, which effectively lowers the rate to 0.6%.

SUTA tax rates vary between states and individual businesses, so check your state government’s website if you need to find yours.

Payroll taxes are flat, but there are exceptions at higher earnings levels. For one, the Social Security portion of the tax only applies to the first $147,000 of compensation for single filers in 2022, though that number updates annually for inflation.

The Medicare portion of the tax applies to all earnings levels, but employees pay an additional 0.9% Medicare tax on income past a certain level. In 2022, that threshold is $200,000 for single filers.

You should use payroll software to calculate your liabilities, but here’s an example to demonstrate the rules. Consider a single employee with a $225,000 wage in 2022. They’d have to pay 6.2% Social Security tax on the first $147,000, which equals $9,114.

They’d also have to pay 1.45% Medicare tax on all $225,000, which equals $3,263. In addition to withholding tax for the employee portion of these tax liabilities, their employer would have to match them. As a result, both parties owe $12,377 so far.

Assuming the employer pays their SUTA taxes and qualifies for the FUTA tax credit, they’d also have to pay 0.6% on the employee’s first $7,000 of taxable wages, which equals $42. The total employer payroll taxes without SUTA are therefore $12,419.

Finally, the employee would owe an additional Medicare tax of 0.9% on the $25,000 they earned beyond the $200,000 threshold. As a result, they’d owe another $225 for a total liability of $12,602.

Accurately tracking your cash flow is essential for proper tax planning. Use our free small business accounting app to organize your financial records automatically!

What is Income Tax?

While the payroll tax only applies to income from an employer, you owe income taxes on just about everything you earn during the tax year. For example, in addition to employment income, that could include:

• Earnings from a side hustle
• Interest on a savings account balance
• Ordinary dividends on taxable investments

Again, unlike the flat payroll tax, federal income taxes are progressive. That means you pay a different tax rate for each earnings range. For instance, the first $10,275 a single person earns is taxable at 10%, but the next $31,500 is taxable at 12% in 2022.

There’s a common misconception that earning more can bump you into a higher income tax bracket, causing all of your income to be taxed more, but that’s not the case. Entering a new tax bracket just means your next dollar is taxable at a higher rate.

While everyone in the United States is subject to federal income taxes, you may also have to pay state income tax or even a local income tax, depending on where you live. State and local taxes can be progressive or flat.

Unlike payroll taxes, the federal government doesn’t use your individual income tax dollars for specific programs. They may go toward supporting healthcare, military, education, transportation, or a wide range of other government expenses.

How is Income Tax Calculated?

Once again, the federal income tax is a progressive tax, which means that higher income ranges have higher tax rates. These are the 2022 federal tax brackets.

2022 Federal Tax Brackets

Source: IRS

Unlike the payroll tax, there are ways to reduce the amount of income taxes you’ll owe in a year besides earning less. That’s because you pay income taxes on your net taxable income rather than your gross wages.

In fact, you can lower your net taxable income in two ways:

• Above-the-line deductions, like contributing to traditional retirement accounts
• Either itemized deductions or the standard deduction

For example, say a single filer earns $75,000 in gross income, contributes $6,000 to a traditional Individual Retirement Account (IRA), and takes the standard tax deduction, which is $12,950 in 2022. Their net taxable income would be $56,050.

They’d pay 10% federal income tax on the first $10,275, 12% on the next $31,500, and 20% on the remaining $14,275. Their total liability would be $7,948. If they didn’t reach that via income tax withholding, they’d pay the difference when they file their tax return.

Whether you’re an employer or an employee, you need to pay the proper payroll and income taxes to stay on the good side of the Internal Revenue Service (IRS). 

As a result, it’s best to get help from a Certified Public Accountant (CPA) if you have a complex tax situation.

Software can help you organize your financial records and make tax time much less stressful. Fortunately, Lendio offers free accounting software for small business. Give it a try today!

*The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.