Payroll tax vs. income tax: What's the difference?

Managing payroll taxes and income taxes is an important responsibility for every business owner, but the complexity of tax regulations and calculations can be overwhelming. Technology is helping, with 42% of owners predicting an AI-assisted future where humans lead operations while using technology as leverage.

To be that leader, you have to understand the underlying math. Whether you're a new entrepreneur or an experienced owner, knowing the distinct roles of payroll and income taxes is essential for maintaining compliance and managing your company's finances effectively

Let’s examine the key differences between payroll tax and income tax and clearly explain each system's unique requirements.

Jump to:

• What is payroll tax?
• What is income tax?
• Differences between payroll tax and income tax
• Key challenges in managing payroll and income taxes
• Best practices for processing income and payroll taxes
• Identifying withholding and income tax terms
• Find peace of mind come tax time

What is payroll tax?

Payroll taxes are specific taxes pulled from an employee's wages to fund social insurance programs. A unique feature of payroll tax is that it is often a shared responsibility. Both the worker and the employer contribute to these funds.

The key components of payroll taxes include:

• Social Security taxes: For 2026, the Social Security tax rate remains 6.2% for the employer and 6.2% for the employee (12.4% total). This is applied to wages up to a specific wage base limit, which is adjusted annually for inflation.
• Medicare tax: The rate for Medicare is 1.45% for the employer and 1.45% for the employee (2.9% total). Unlike Social Security, there is no wage limit for the Medicare tax. High earners may also be subject to an Additional Medicare Tax.
• Federal unemployment taxes (FUTA): Employers alone pay this tax. The FUTA rate is 6% on the first $7,000 paid to each employee annually, though credits are often available for timely state unemployment tax payments.
• State unemployment taxes (SUTA): These vary by state and are used to fund unemployment benefits at the local level.

These taxes are governed by the Federal Insurance Contributions Act (FICA), state unemployment tax regulations, and the FUTA. Together, they provide a safety net for retirees, people with disabilities, and workers who lose their jobs.

What is income tax?

Income tax is a levy imposed by the federal government and most state governments on the financial income of individuals and businesses. While payroll taxes fund specific social programs, income taxes pay for things like national defense, infrastructure, and public education.

The key components of income taxes:

• Taxable income: This includes more than just hourly wages or a salary. It covers interest, dividends, rents, royalties, and business profits.
• Progressive tax rates: Federal income tax is progressive. This means that as an individual earns more, the additional income is taxed at higher rates. Currently, federal brackets range from 10% to 37%.
• Deductions and credits: Taxpayers can reduce what they owe through tax breaks or deductions (like home mortgage interest) or credits (like the Child Tax Credit).
• Withholding requirements: Even though the tax belongs to the employee, employers are responsible for calculating and withholding the correct amount based on the employee's Form W-4.

Differences between payroll tax and income tax

Payroll tax and income tax are distinct types of taxes that serve different purposes and have different applications. Here are some key differences:

Responsibilities for employers and employees

The employer is responsible for calculating the correct amounts, withholding the employee's share, and remitting those funds to the IRS and state agencies. The employer also pays their own matching share of FICA and the full cost of FUTA.

The employee is responsible for providing accurate information on Form W-4 so the employer knows how much income tax to withhold. At the end of the year, the employee files a tax return to determine if the amount withheld throughout the year covers their total income tax liability.

Payroll tax example

Currently, the employer’s payroll expense is a 6.2% Social Security tax and a 1.45% Medicare tax (7.65% in total). Each worker pays the same 7.65% tax through payroll withholdings up to the Social Security wage threshold.

The current employer’s FUTA tax rate is 6% on the first $7,000 in gross income earned by the worker. The total federal and state unemployment taxes will vary depending on each state’s unemployment program. Employers are responsible for passing the payroll taxes to the appropriate taxing authorities. This includes both the amounts withheld from employees' paychecks and the employer contributions.

Here’s an example of how to calculate payroll taxes for an employee with a total income of $25,000 for the year:

• Employee tax (FICA): $25,000 x 15.3% = $3,825
• 7.65% paid by the employer = $1,912.50
• 7.65% paid by the employee = $1,912.50
• FUTA tax for one employee: $7,000 x 6% = $420 paid by the employer

Income tax example

To calculate income tax, first determine an employee’s gross income, which includes wages, salaries, and any other sources of income.

Gross wages may be calculated based on an annual salary or determined using an hourly rate of pay and hours worked. The gross wages paid are your largest payroll expense and include payments to employees and independent contractors.

After that, determine whether they qualify for any adjustments to income, such as contributions to retirement accounts. Then, subtract the total of those adjustments from their gross income to determine how much income is taxable.

To determine how much income tax to withhold, refer to the IRS withholding tables or go worry-free with payroll software, such as QuickBooks, that calculates these for you.

Key challenges in managing payroll and income taxes

Handling taxes requires staying on top of changing regulations and maintaining meticulous records. Staying compliant in 2026 involves addressing several modern workplace challenges.

Handling multi-state employment

The rise of remote work means many businesses have employees living in different states. You must track where the work actually takes place. This often triggers a tax nexus, requiring you to register with that state's department of revenue and withhold taxes based on its specific laws.

Correct worker classification

Determining whether a worker is an employee or an independent contractor is vital. If a worker is an employee, you must handle all payroll and income tax withholdings.

For independent contractors, you generally don’t withhold taxes. The contractor is responsible for their own self-employment and income taxes.

Maintaining records for audits

To stay ready for a potential payroll tax audit, keep organized records for at least four years. This includes:

• Signed W-4 and I-9 forms
• Records of all tax deposits made
• Worker classification documentation
• Pay stubs and payroll summaries

Best practices for processing income and payroll taxes

When processing payroll, there are a couple of best practices to follow for handling payroll tax and income tax:

Consider other withholdings

Employers may have to withhold additional amounts that are not related to taxes, such as the worker’s share of health insurance premiums. To pay workers, you start with gross pay (unpaid wages) and deduct withholdings to calculate net pay.

Some withholdings are for taxes, and others are not. Not all workers have taxes withheld from pay, and you need to classify workers as either employees or independent contractors.

Categorize employees and independent contractors

A worker’s classification determines how the worker is treated for tax purposes. If the worker is an employee, you’ll incur payroll expenses.

Independent contractors, on the other hand, are personally responsible for all payroll withholdings, and the company’s only expense is the gross amount paid for services.

Track voluntary deductions

If your business offers benefits, you may withhold a portion of the costs from the worker’s pay. The employer’s share of the costs is a payroll expense. Here are some examples:

• Retirement plan: The employee contributions are deducted from pay and are not an employer expense. However, the employer’s share of contributions is a payroll expense for the business. Employer contributions are not deducted from pay.
• Health, dental, vision, and life insurance premiums: Premiums paid by the employer are not withheld from pay and are included as business expenses. The worker’s share of premiums is deducted from pay and is not a payroll expense.
• Union dues: Dues are deducted from pay and forwarded to the union on the worker’s behalf. The payments are not a payroll expense.
• Loan payments: If an employee has a loan from the business, repayments may be deducted from pay and are not a payroll expense.

The cost incurred to retain an accountant or a payroll provider is a business expense. Once you understand the payroll expenses you must incur, create a written procedure that documents how you process payroll.

Identifying withholding and income tax terms

There are often questions regarding how these terms overlap in daily practice. Here are some clarifications on common tax scenarios.

The definition of withholding tax

Withholding tax is the amount an employer takes directly out of an employee's paycheck and pays to the government. The employee's earnings and the information provided on their Form W-4 determine the withholding amount.

Managing remote and multi-state workers

When employees work across state lines, you must track the days worked in each location. Most states have specific thresholds that trigger tax obligations. You may need to register your business in multiple states and withhold taxes based on each state’s unique requirements and rates.

Find peace of mind come tax time

Distinguishing between payroll and income taxes is a foundational skill for any business owner. While the rules can be complex, establishing a clear process helps you avoid errors and keeps your focus on growing your business.

Moving away from manual spreadsheets and using a dedicated payroll service can help ensure that calculations for Social Security, Medicare, and federal withholding are accurate and paid on time.

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