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

To complete payroll, you must calculate withholdings and submit them to third parties, which means you’re in tax territory. But if you understand the relationship between income taxes and payroll taxes, managing payroll is much easier.

If some tax terms sound foreign to you, this guide goes over the difference between payroll tax vs. income tax, how to calculate them, and best practices to follow.

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 generally the worker (employee) and the employer both 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 the number of allowances computed on their Form W-4. Withholding amounts are passed through to each taxing authority, and the amounts are not an employer expense.
• Social Security taxes: The current rate for social security is 6.2% for the employer and 6.2% for the employee—totaling 12.4%. For 2023, up to $160, 200 (set to rise to $168,600 for 2024) 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 unemployment taxes. The total federal and state unemployment taxes (SUTA) paid will vary depending on each state’s unemployment program. Currently, the FUTA tax rate employers pay is 6% on the first $7,000 paid to each employee in gross wages during the year. At a state level, the amount of income subject to unemployment tax may be different depending on the state’s rules. 
• State and local income taxes: Most states require employers may also need to withhold state and sometimes local income taxes from employees' wages. Currently very few states do not charge an income tax.

The Federal Insurance Contributions Act (FICA) taxes fund Medicare and Social Security and the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA) were passed to 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 individuals, businesses, and many other entities based on their income or profits. Individuals have assessed taxes on many forms of income not just limited to their salary, including interest, dividends, rents, royalties, lottery and gambling winnings, unemployment benefits, and earnings from businesses they own. 

As of 2023, there are only eight states (Alaska, Florida, Nevada, South Dakota, Texas, Tennessee, Washington, and Wyoming) that do not charge an income tax.

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 generally higher income levels are taxed at higher rates. Tax rates can vary by state. 
• Deductions and credits: Taxpayers may qualify for deductions and 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. Afterward, they go 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: Payroll tax is a tax the government levies 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.

How to calculate payroll tax

Workers and employers must contribute to Medicare, Social Security, and unemployment compensation by paying payroll taxes. Ultimately, the worker’s gross income determines how much they’ll pay for each of these programs.

The amount deducted is based on the worker’s annual income and the number of allowances computed on Form W-4. Employers will then pass withholding amounts to each taxing authority.

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. If the wages are subject to a state unemployment tax, the employer can use a 5.4% FUTA credit, which reduces the FUTA tax to 0.6%. The total federal and state unemployment taxes will vary depending on each state’s unemployment program.

Here’s an example of how to calculate payroll taxes, if their total income for the year is $25,000: 

• 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

How to calculate income tax

To calculate income tax you must 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, HSA contributions, and other benefits and deductions. 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.

Best practices for processing payroll and income 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 tax withholdings, and the company’s only expense is the gross amount paid for services.

The Internal Revenue Service (IRS) provides a guide that explains how to classify workers to a particular category. The terms of your working relationship determine if the worker is considered an employee or an independent contractor.

The guidelines consider how much control the business has over what the worker does, who provides tools and supplies, and whether you have a written contract. If you have a large amount of control over how and when the worker performs services, they’re likely an employee.

Consider 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 service company is a business expense. Once you understand the payroll expenses you must incur, create a written procedure that documents how you process payroll.

Complete payroll tax forms

Payroll tax returns are complex, and the information you submit must be accurate. Make sure to submit the forms on time to avoid late filing fees. Here are the most common payroll tax forms businesses must submit:

• Form 941: Reports federal income taxes and FICA taxes to the IRS each quarter.
• Form 940: Employer’s annual federal unemployment (FUTA) tax return.
• Form W-3: Reports the total wages and tax withholdings for each employee using W-2 forms. Businesses file the report with the Social Security Administration annually.
• Form 1096: Reports the dollars paid to independent contractors using 1099 forms. Businesses file this report annually.

Accounting software allows you to generate these reports automatically.

Find peace of mind come tax time

Understanding the difference between payroll tax vs. income tax can help you process your payroll faster and maintain compliance. Use a payroll software or service to process payroll, and take steps to minimize the use of spreadsheets. With these tips in mind, you can save time and process payroll accurately.

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