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. 

Whether you're a new entrepreneur or an experienced business owner, understanding 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
• Find peace of mind come tax time
• Frequently asked questions

What is payroll tax?

Payroll taxes include income taxes and taxes assessed for Social Security, Medicare, and unemployment compensation. It’s important to note that both the worker (employee) and the employer generally have to pay these taxes. 

The key components of payroll taxes include: 

• Federal income tax withholding: Businesses must deduct federal income taxes from wages. The amount depends on the worker’s annual income and other information reported on their Form W-4. 
• Social Security taxes: The current rate for Social Security is 6.2% for the employer and 6.2% for the employee—totaling 12.4%. Up to $168,600 for 2024 ($176,100) of taxable wages are subject to Social Security tax.
• Medicare tax: The current rate for medicare tax is 1.45% for the employer and 1.45% for the employee, or 2.9% total. 
• Unemployment taxes: Most employers must pay both federal (FUTA) and state (SUTA) unemployment taxes. Currently, the FUTA tax rate employers pay is 6% on the first $7,000 paid to each employee in gross wages during the year.
• State and local income taxes: Most states require employers may also need to withhold state and sometimes local income taxes from employees' wages.

The Federal Insurance Contributions Act (FICA) taxes fund Medicare and Social Security, while the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA) provide temporary income for workers who lose employment.

What is income tax?

Income tax is a type of tax the federal government (and most states) impose on the income or profits of individuals, businesses, and entities based on their income or profits. 

Taxes on individual income typically include salary, interest, dividends, rents, royalties, lottery and gambling winnings, unemployment benefits, and earnings from businesses they own, like solopreneurships. 

The key components of income taxes include:

• Taxable incomes: The portion of a worker’s or entity’s income subject to taxation, including wages, salaries, and business profits.
• Tax rates: Income tax is typically imposed at progressive rates, so higher income levels are generally taxed at higher rates. Tax rates can vary by state. 
• Deductions and credits: Taxpayers may qualify for tax breaks credits that can reduce their taxable income. Some examples include charitable contributions and certain business expenses. 
• Withholding: Employers must also withhold a portion of employees’ wages for income tax purposes. Self-employed individuals and businesses are often responsible for making quarterly estimated tax payments.

Payroll processing requires businesses to withhold income taxes on employee wages. Then, the taxes are sent to the appropriate taxing authority (the federal, state, or local department of revenue).

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 between payroll taxes vs. income taxes:

• Application: Payroll tax applies to employees' wages and salaries. Income tax applies to various income sources, including wages, salaries, and business profits. 
• Tax rates: The current federal payroll tax rate is 15.3%, which includes both the employer and employee’s contributions. The federal income tax rate ranges from 10% to 37%.
• Tax levies: The government levies payroll tax on employers and employees, while income tax is levied on individuals’ salaries, wages, and other incomes. 
• Usage: Payroll taxes generally fund three specific programs: Social Security, Medicare, and unemployment benefits. Income taxes fund a wider array of public services and expenditures. 

The employer is responsible for withholding the employer’s share of payroll taxes, reporting employee earnings, and remitting deductions from employees’ wages. 

The employee is responsible for paying federal and state payroll taxes, as well as their income tax.

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.

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 

Managing payroll and income taxes comes with complex challenges for small business owners and self-employed individuals. 

Some of the biggest challenges include: 

• Complying with multiple tax laws: One of the biggest challenges businesses face is complying with various federal, state, and local tax requirements. Different tax authorities often have distinct filing schedules and requirements. 
• Managing remote workers: The rise of remote work has introduced new complexities in tax management. When employees work across state lines, businesses must navigate complex tax obligations. 
• Recordkeeping challenges: Accurate recordkeeping is important for tax compliance but can be overwhelming. Businesses must maintain employee tax forms (W-2s, W-4s, 1099s), payroll records and pay stubs, tax payment documentation, and state and federal tax filings. 

Addressing these key challenges means having a system that streamlines paying your salaried and 1099 employees. Let’s look at some key ways to manage payroll taxes. 

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.

Find peace of mind come tax time

Knowing the distinctions between payroll and income taxes is fundamental to running a successful business, but knowledge alone isn't enough. Tax management isn't just about meeting obligations—it's about creating sustainable processes that support your business's growth and success.

Use a payroll service to process payroll, and take steps to minimize the use of manual systems. With these tips in mind, you can save time and process payroll accurately.

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