Payroll taxes are amounts of pay withheld from an employee’s paycheck during the payroll process, and employers must usually match these amounts. Payroll taxes contributed a major part of the U.S. federal budget, particularly for social insurance programs.
Definition and Examples of Payroll Taxes
Some payroll taxes are also known as “FICA taxes.” FICA stands for the “Federal Insurance Contributions Act,” and includes Social Security and Medicare taxes. Unemployment insurance is also a payroll tax, but it’s not considered to be a FICA tax.
- Alternate name: FICA taxes
Social Security Taxes
Social Security taxes refer to FICA-mandated taxes that pay for old-age, survivors, and disability insurance (OASDI). The tax contributed 88% to OASDI in 2019. These programs are also funded by income taxes levied on Social Security benefits that are paid out. There’s a cap on the Social Security tax. You won’t have to pay it on any portion of your wages or salary that exceeds a certain threshold.
The Social Security tax was levied at just 1% in 1937 when it was first imposed, but it’s increased significantly since then.
Medicare taxes fund the nation’s hospital insurance (HI) program. This tax pays for hospital stays, some home health care, and hospice care for qualifying individuals. It’s expanded to Medicare Advantage plans and prescription drug costs since the tax’s inception. It contributed 36% to these programs in 2019.
There’s no salary or earnings cap on the Medicare tax. In fact, high earners are hit with an extra tax, known as the Additional Medicare tax.
Payroll taxes raise significant revenue. They generated $1.24 trillion in 2019, according to the Center on Budget and Policy Priorities. This works out to 5.9% of the country’s gross domestic product (GDP) and 35.9% of the nation’s overall revenues. Social Security alone received $914 billion from payroll taxes, making them the second-highest source of income for the federal government behind income taxes.
How Payroll Taxes Work
Payroll taxes are levied as a certain percentage of your earnings. Your employer typically pays half this percentage and you pay the other half through paycheck withholdings. Employers are legally obligated to contribute to these taxes and report the amounts withheld from employees’ pay on Form W-2. Your employer sends the contribution information to the IRS after year’s end.
Employers must keep this money in a dedicated account and deposit these amounts with the federal government according to a monthly or semiweekly schedule. Unemployment taxes must be paid quarterly whenever you owe more than $500. Employers are responsible for paying all unemployment tax you owe.
The self-employed must pay all payroll taxes because existing tax law considers them to be both employer and employee. Their Social Security and Medicare taxes are collectively referred to as the self-employment tax, provided for under the Self-Employment Contributions Act (SECA).
Types of Payroll Taxes
There are four payroll taxes: Social Security, Medicare, Additional Medicare Tax, and Federal Unemployment Tax.
Social Security Tax
This payroll tax is levied at 12.4% (split evenly between employer and employee). Of this 12.4%, 10.6% goes to an OASI fund for retirement benefits and survivors, and the other 1.8% goes to disability insurance.
The Social Security tax is payable only on annual earnings up to $142,800 in 2021. Income above $142,800 isn’t subject to the Social Security tax—but only for the remainder of the year. Your earnings reset to zero on Jan. 1 of the next year.
The wage base is indexed for inflation, so it can be expected to increase in 2022. It was $137,700 in 2020, up from $132,900 in 2019.
Sometimes called “HI” or “MEDFICA,” this payroll tax contributes to Part A Medicare benefits for senior taxpayers and those with certain illnesses or impairments. Other parts of Medicare aren’t covered. The tax is 2.9%: The employee and employer pay 1.45% each. This tax was capped at a certain amount of annual earnings, but the cap was eliminated from the federal code in 1994.
Social Security and Medicare tax rates are the same for self-employed taxpayers. The only difference is that they have to pay the total percentage, not just half.
Additional Medicare Tax
The Additional Medicare Tax is 0.9% as of 2021, and employers are obligated to withhold this from a worker’s paycheck as well, but they don’t have to match it.
It’s only payable on earnings of more than $200,000 for single taxpayers, or $250,000 for those who are married. The income threshold drops to just $125,000 if you’re married filing separately.
Those who earn more than the threshold will pay regular Medicare tax and the Additional Medicare tax.
States pay unemployment compensation to workers who’ve lost their jobs. States partner with the federal government to provide for this program. Unemployment taxes collected from employers are placed in a federal trust fund. Employees don’t have to contribute to this payroll tax.
The unemployment tax rate is 6% of earnings paid up to $7,000, but the federal government provides tax credits that can bring this down to just 0.6%. Unemployment tax is payable at the state level as well.
Drawbacks of Payroll Taxes
All these taxes add up to a good bit of money, which has led to quite a bit of debate over the years.
It’s been argued that employers effectively pass on their share of Social Security and Medicare taxes by paying workers 7.65% less than they would have otherwise—half of that 15.3% total—to compensate for having to pay their own half of these taxes. Their payroll tax obligation results in lower wages to employees, and employees still have to pay their 7.65% share.
Lower-income workers also pay that Social Security tax on all their earnings, while high earners don’t have to once they reach the wage-base threshold, at least for the remainder of the year.
But high earners are at a bit of a disadvantage because of the additional Medicare tax. They’re paying more into the Medicare system, but the services they’re eligible for are the same as what taxpayers who contribute less receive. Then again, high earners aren’t taxed for Social Security on income above the threshold, but they’re eligible to collect Social Security when the time comes.
- Payroll taxes are made up of four separate taxes: Social Security, Medicare, Additional Medicare, and unemployment insurance tax. All workers don’t pay all of these, however.
- Employers and employees share the Social Security and Medicare tax, each paying half but self-employed individuals must pay both halves.
- The additional Medicare tax is reserved for high earners. Employers don’t have to share in this tax.
- Employees don’t have to contribute to the unemployment insurance tax.