Payroll tax vs. income tax: differences, calculation, and best practices

If you’ve ever run payroll, you’re familiar with the challenges that come from accurately calculating FICA, FUTA, and personal income taxes for your employees. But have you ever wondered why employers withhold income taxes as part of payroll taxes? Or why employers transmit those funds to the IRS and state revenue authorities on behalf of employees? Does that mean income tax is a payroll tax? 

In this guide, we’ll unpack the similarities (and differences) between payroll and income taxes and review examples of how to calculate each.

What is payroll tax? 

Payroll taxes are taxes paid by employers and employees on salaries, wages, and tips to fund national, state, and sometimes local public programs. Employers are responsible for calculating the correct amounts–usually a percentage of an employee’s taxable compensation–withholding money from employee paychecks, and making scheduled payments to federal and state tax authorities. 

Like many other countries, the US uses payroll taxes to support certain healthcare and insurance programs. Employers also withhold a portion of an employee’s income taxes and remit them on their behalf. In the US, the main payroll taxes include:

• FICA. Named for the Federal Insurance Contributions Act, FICA taxes support Social Security and Medicare. Employees and employers each pay 6.2% of the employee’s gross compensation up to $176,100 towards Social Security and 1.45% each towards Medicare.
• FUTA. The Federal Unemployment Tax Act requires employers to pay an amount equal to 6% of the first $7,000 an employee earns towards a national unemployment insurance program. States also fund their own unemployment programs through payroll taxes (SUTA).
• State and local taxes.  Individual states also use payroll taxes to support state-level initiatives. In California, for example, employers pay an Employment Training Tax, while Oregon assesses a payroll tax on companies and residents in the Eugene area to fund public transit.
• Personal income taxes. In the US, employees pay a portion of the income taxes owed on salaries, wages, and tips through withholdings computed by their employer based on information in the employee’s Form W-4.

What is income tax?

Income tax is a tax paid by individuals, businesses, and organizations on personal revenues and profits. All US citizens and residents must pay federal income taxes, and most US states also impose an income tax. Exceptions to the state income tax requirement include Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Income taxes are 100% an individual employee's responsibility; however, the employer calculates and pays them on their behalf based on information provided by the employee in a Form W-4 at the time of hire.     

Federal, state, and local governments use income taxes to fund various benefits, programs, and initiatives. At the federal level, tax dollars may support defense and healthcare spending, while states use income taxes to pay for public schools or infrastructure. In general, the main components of federal or state income tax are:

• Taxable income. “Income” includes not only wages and salaries, but also interest, dividends, rents, and royalties. 
• Tax rates. The federal government and most states apply a progressive tax rate, which means that taxes increase as income grows. Someone earning less than $12,000 annually will pay 10% of their income in federal taxes, while someone earning over $250,500 will pay 35%. 
• Deductions and credits. Both businesses and individuals can qualify for deductions and credits that reduce their overall tax liability. For example, a company could deduct qualifying business expenses, while parents can claim a tax credit for qualifying children.
• Withholdings. The amount an employer withholds from an employee’s paycheck will vary depending on the employee’s selections on their Form W-4. A married person filing jointly may have less withheld than one who checks off “married but withhold at single rate,” for example. 

Similarities between payroll tax and income tax

You may have noticed that we included “personal income taxes” in our list of payroll taxes. Because employers take responsibility for calculating the tax owed on that source of income and transferring funds to the IRS and state revenue authorities on behalf of employees, income tax is a payroll tax. 

It may help to think of it this way, “income tax” refers to what’s being taxed: the employee’s income from wages, salaries, or tips. “Payroll tax,” on the other hand, refers to how that tax gets paid: deductions from the employee’s monthly paycheck.

Of course, personal income taxes can apply to sources other than salaries, such as interests, dividends, or rental income. That’s why individuals file an annual tax return that captures all revenue sources beyond what they might have earned working as a W-2 employee or a 1099 contractor.

Payroll tax vs. Income tax: key differences

The difference between income tax and payroll tax lies primarily in their purpose and scope. Both are withheld from employees’ paychecks to fund government programs, but in slightly different ways.

Tax rates

The current federal payroll tax rate is set at 12.4%-15.3% for Social Security and 2.9% for Medicare. Federal income taxes, on the other hand, range from 10% of an individual’s taxable income to 35%.

Usage

While payroll taxes apply only to earned income, people and businesses pay income taxes on most types of revenue. Payroll taxes fund specific social programs, while income taxes cover all kinds of government spending, from farming subsidies to military aircraft to civil servant salaries. 

Who pays them

Employees and employers split the cost of FICA taxes equally, paying 6.2% and 1.45%, respectively. However, employers have sole responsibility for FUTA and SUTA taxes, and employees pay their own income taxes. 

Tax levies

Federal and state governments levy income taxes on employers and employees. Personal income taxes are levied on salaries, wages, tips, and other sources of revenue.

How much is payroll tax and how do you calculate it?

How much payroll tax your business pays depends on your workforce's size and overall payroll. In general, the more employees you have and the more you pay them, the higher your payroll taxes.

To calculate payroll taxes, you’ll apply a set of government-applied formulas to find your employee’s taxable income, subtract any mandatory or voluntary deductions, and add back expense reimbursements.

• Determine employee’s taxable income. Start by calculating your employee’s earnings before payroll taxes or pre-tax deductions are withheld. Multiply the number of hours worked during the pay period by the hourly rate for hourly employees and divide the total annual salary by the number of pay periods for a salaried worker. 
• Subtract FICA taxes. Employers and employees contribute equally to FICA taxes. Note that when an employee earns over $200,000, you’ll split an additional Medicare tax of 1.8%. 
• Subtract voluntary withholdings. If your employee purchased health or life insurance through your benefits program or contributes to a 401(k), you’ll deduct the monthly payments from their pre- or post-tax income.
• Add expense reimbursements. If your organization reimburses employees for particular expenses, such as business lunches or travel, you’ll add that money back in as a final step.

Payroll tax example

To illustrate how payroll tax calculations might play out, let’s consider a hypothetical HR assistant named Alex. Alex works for Acme Corp. and earns $75,000 in annual gross income. 

• Step 1. Acme Corp. pays employees bi-monthly. Divide $75,000 by 24 pay periods to find Alex's gross income. ($75,000 / 24 =  $3,125.) 
• Step 2. Alex is married and files a joint return with their spouse. Alex has also checked the box in Section 2 of Form W-4 indicating that their spouse is employed.  Based on the IRS wage tables, Acme Corp. withholds $226 from each of Alex’s paychecks, plus 22% of compensation above $2,573.
• Step 3. Based on earnings of $3,125 per pay period, Alex contributes $193.75 to Social Security and $45.31 to Medicare from each paycheck. That 6.2% and 1.45% of $3,125, respectively.
• Step 4. Alex has purchased retirement savings and healthcare through company-sponsored benefits programs. Acme Corp. deducts Alex’s contributions from their pre-tax income. Alex also purchased life insurance, payments for which Acme Corp. deducts after withholding FICA, FIT, and retirement and healthcare payments.
• Step 5. During the last pay period, Alex personally purchased supplies for an office party and submitted receipts for approval. Acme Corp. reimburses Alex for these expenses as the final step of processing their paycheck.

How much is income tax and how do you calculate it?

Because the US uses a progressive tax system for federal income taxes, the amount of income tax you owe increases along with your income. The more you earn, the higher your tax rate. Other factors that affect your personal income tax rate include your filing status (single, head of household, married) and, in the case of state income taxes, where you live. Texas doesn’t levy income taxes, Colorado imposes a flat tax, and New York uses a progressive percentage system.

Employers calculating personal income tax withholdings on behalf of employees will follow these steps:

• Determine the employee’s taxable income. For hourly employees, simply multiply the hourly rate by the number of hours worked. Divide the total annual salary by the number of pay periods for a salaried employee. 
• Choose between the percentage method or the wage bracket method. The IRS allows two different withholding methods. If you opt for the percentage method, you’ll apply different tax rates to different portions of the employee’s income using a formula provided by the IRS. The wage bracket method involves matching the employee’s filing status and income to tables provided by the IRS and withholding the prescribed amount. 
• Consult the IRS withholding tables. Once you’ve chosen your withholding method, review an employee’s Form W-4 for information about marital status, dependents, and other adjustments. Next, consult the IRS’ withholding tables for guidance on wage levels and any state-level guidance. 

Income tax example

Taylor earns $50,000 annually as a graphic designer for Agency, Inc. Agency, Inc. pays its employees monthly and uses the percentage method to calculate personal income tax withholdings. Taylor’s filing status is ‘single.’ 

• Step 1. Because Agency, Inc. pays employees once a month, divide $50,000 by 12 to find Taylor’s gross income per paycheck (50,000 / 12 = 4,166).
• Step 2. Agency Inc. applies the percentage method, which means that different portions of Taylor’s paycheck are taxed at different rates. 
• Step 3. After consulting the IRS’ withholding tables, Agency, Inc. withholds $752 in personal income taxes, plus 32% of each paycheck over $3,972. Taylor’s total personal income tax withholding amounts to $814.08.

Challenges of payroll and income taxes for businesses 

Beyond navigating different state and federal withholding rates and applying the IRS’ wage bracket method, finance and HR teams can face ‘big-picture’ challenges when it comes to payroll and income tax withholding. Challenges like: 

• Compliance with tax laws. Federal and state tax authorities may require businesses to file or pay payroll taxes on different schedules. California, Oregon, and New York require employers to pay certain payroll taxes every quarter, whereas the IRS asks employers to pay monthly or semi-weekly.
• Handling payroll for remote workers. Rules on how to and where remote workers pay taxes are far from standard. A team member working for a Boston company who lives in Austin, for example, may owe state income taxes to Massachusetts even though Texas doesn’t levy them. 
• Accurate record keeping. Payroll taxes have the potential to generate a lot of paperwork. From required forms to pay stubs to internal reports, staying on top of the documents and records your business needs to accurately pay and file can be challenging without an efficient system.

Best practices for payroll and income tax management

Whether you use an automated payroll management solution or a pared-down collection of tools to handle payroll, your organization’s policies and procedures serve as the foundation for accurate withholding and payment.

1. Follow federal and state regulations

Avoid unnecessary penalties and fines by submitting payroll taxes promptly. The IRS publishes a list of employment tax due dates that you can use as a basis for automated reminders and payments, depending on your payroll management system. Many state revenue agencies also share important deadlines online.

2. Categorize employees and contractors

Correctly classifying your workers is crucial to accurate payroll processing. You don’t want to inadvertently withhold payroll taxes from an independent contractor or overlook a Form W-2 for a qualifying employee. 

3. Remember voluntary deductions

Depending on the benefits your organization offers employees, you may have other deductions to think about beyond FICA, FUTA, and income taxes. Employees who purchase private health or life insurance through a company-administered benefit plan will need their monthly payments deducted from their paychecks, for example.

Rippling: Easy payroll and income tax management

If you want payroll so powerful it runs itself, you want Rippling Payroll. Rippling offers full-service payroll built on top of a single source of truth for employee data. That means your employee data isn’t tied to one specific app—it’s the same across payroll, time and attendance, onboarding, performance management, and any other apps you use within our unified platform. Small businesses do more with less—less money, less headcount, and less time. And all with a 100% error-free guarantee.

With Rippling you can: 

• Automatically calculate taxes and net pay. Rippling Payroll automatically applies appropriate deductions to an employee’s gross pay based on time and attendance data, tax filing information, and PTO policies.
• Pay employees. Once you click ‘run payroll,’ Rippling debits your bank account, makes direct deposits to employees, and distributes paystubs.
• Prepare state and federal payroll tax filings. Rippling Payroll prepares your organization’s federal and state payroll taxes. All you need to do is review and approve, and Rippling ensures you never miss a filing deadline.
• Automatically update your general ledger. Sync Rippling Payroll with your general ledger to automate updates and entries.

FAQs on payroll tax vs income tax

Who is exempt from federal income tax?

People with a total income less than the annual thresholds set by the IRS are exempt from paying federal income taxes. Depending on filing status, this amount can range from $13,850 to $29,200. Typically, the filing exemption applies to low-income earners, dependents and children, non-profit organizations, or retirees who rely on Social Security. 

Can payroll taxes be deducted from income tax?

Self-employed individuals can deduct the portion of FICA taxes that an employer would otherwise pay from their personal income taxes. Regular employees who receive a Form W-2 cannot deduct payroll taxes withheld from their paychecks by employers from their income taxes. 

Do workers pay more in payroll taxes than they pay in income taxes?

Whether workers pay more in payroll taxes than income taxes depends largely on earnings. For lower-income workers, payroll taxes can consume a larger percentage of overall earnings because they apply immediately and can’t be offset with credits or deductions. Workers who earn more may eventually find themselves in a tax bracket that exceeds the combined payroll tax limit of 7.65%, which means they’ll pay more in federal income taxes than payroll taxes.

Is income tax paid the same as income tax withheld?

No, income tax paid is not necessarily the same as income tax withheld. When an individual’s overall tax bill, after factoring in deductions and credits, exceeds the amount withheld by an employer, the individual will need to pay the difference.

This blog is based on information available to Rippling as of November 4, 2024.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.