What Is a Payroll Tax?


When you get paid you don’t get all the money your employer "owes" you. If you look at your paycheck stub, you’ll see that payroll taxes have been deducted. There are also other payroll taxes that your employer is responsible for. The taxes employers pay provide unemployment benefits and help fund Social Security and Medicare.


A payroll tax is money deducted from an employee’s earnings when he is paid or which is paid by the employer. These taxes fund government entities or programs. At one time, everyone paid their taxes separately from their paychecks. It became a hardship for many people to pay out a large lump sum (it also made it harder for the government to collect the taxes). Deducting taxes gradually and before a person ever received the money proved to be more convenient for both taxpayers and for the governments, so that’s how it’s done today.


There are four basic types of payroll taxes that the employee pays. Federal income tax goes to fund the United States government and helps pay for the military, federal law enforcement and many other programs. Social Security (FICA) is an employee’s contribution to the Social Security system and pays for retirement and disability benefits. Medicare taxes help provide low-cost health insurance for persons who are retired or who have disabilities. State income taxes finance various activities at the state level.


The origin of payroll taxes goes back to an 1894 federal income tax law that was declared unconstitutional by the U.S. Supreme Court. This led to the passage of the 16th Amendment to the Constitution, which was ratified in 1913 and made direct taxes (and therefore income taxes) legal. At first income taxes were not deducted from paychecks. After World War II the laws were changed and taxes were deducted from each paycheck so people were not faced with a big lump sum to pay every April 15. The Social Security tax was added in 1935 and Medicare in 1965. Over the years 41 states have enacted income tax laws, as well.


Each payroll tax is calculated with a different formula. Social Security is easy to figure out. It’s 6.2 percent of your gross income up to the maximum (for 2008 this was $102,000). Medicare is 1.45 percent of your gross income, no matter how much you make. Figuring the federal income tax is more complicated, because you have withholding allowances and it’s on a sliding scale. For instance, a single person with one withholding allowance is taxed on their gross pay minus the amount of the withholding allowance (for weekly paychecks, $67.61 in 2008). If you made $500, you’re taxed on $500 - $67.61 or $432.39. Using the IRS’s formula, the first $51 of that isn’t taxed, the next $198 is taxed at 10 percent, and everything over that at $15 percent (the total is $42.21). States taxes each have a different formula, but are usually on a sliding scale similar to the federal income tax.


The Federal Unemployment Tax Act (FUTA) requires employers to pay an amount up to 6.2 percent of an employee’s wages to fund unemployment benefits for workers who lose their jobs through no fault of their own. In practice, employers pay a much smaller amount (usually 0.8 percent) due to tax credits for paying state unemployment taxes under the State Unemployment Tax Authority (SUTA). In addition to the FUTA and SUTA taxes, employers match the employee’s Social Security and Medicare tax dollar for dollar.


It’s important to realize that your payroll taxes are an estimate of how much you owe in taxes. You can do a lot to reduce this. Keep records of any medical, education, or work-related expenses, along with records of the interest paid on any mortgage. Most or all of those things will be tax deductible. Do some research and find out what other tax deductions you might qualify for, including donations to charitable causes. You can reduce your taxes by taking advantage of the tax shelters provided by Individual Retirement Accounts (IRAs). If you work two jobs, keep in mind that your tax for each paycheck is figured on the basis of one job. To avoid owing a large sum when you file your taxes, you can request that one or both of your employers withhold an additional sum each payday (if you have them withhold too much, you‘ll get it back as a tax refund).

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