Hi everyone, Today we are gonna talk about how to calculate payroll taxes. Now it's important to acknowledge that most small business owners use payroll software or outsource their payroll. So they don't see or have to deal with these calculations to generate a proper paycheck. However, it behooves every small business owner to understand what is happening behind the scenes of the payroll software or service and understand how their wage expenses are distributed and essentially, how their employee’s net paychecks are calculated.
We're going to split tax calculation into two groups. We're gonna have federal and state and local. Additionally, you will learn about employee versus employer taxes because both parties incur tax in one way or the other. When I mention employees’ taxes, these are the ones that you can see in their paychecks as a reduction towards their net pay. While the employer taxes are accrued by the employer simultaneously and they're not seen on the paychecks. Both of these are remitted by the employer as part of the responsibility.
Let's start with federal taxes, AKA the IRS.
Employees will see in their paychecks three types of federal taxes. First, they're gonna see federal withholding, which is typically tied to the tax bracket of the employee depending on their income level and marital status. There's a publication by the IRS called Publication 15-T, that has information about all of these tax tables.
There's also Social Security withholding, which is split between employee and employer. So the employee sees 50% of the total amount in their paycheck. As of 2021, the total rate of employee wages towards Social Security is 12.4, which half is paid by the employer and half by the employee. The Social Security withholding limit is to the first $142,800 of their wages, and after that, there's no more Social Security withholding. Beyond 2021. you can expect that limit to increase every year by 3 to 5% as it has done in the past.
This number is announced and published by both the IRS and the Social Security Administration every year. Next, is Medicare withholding. This is also split between employers and employees and the total amount is 2.9% of those gross wages. Medicare doesn't have a limit or a cap-like Social Security, so it's applied at all income levels.
The combined tax of Social Security and Medicare is often referred to as FICA, which is a total of 15.3% of the wages that is paid 7.65 by the employee and 7.65 by the employer. Beyond the matching of the FICA tax that we mention here, the employer also has additional taxes.
We have the federal unemployment tax often referred to as FUTA, this tax in 2021 could be as slow as 0.6% to as high as 6% of the first $7,000 worth of wages. Depending on the state that you're in and whether or not they will get a special credit of 5.4% reduction if you have paid the state version of the unemployment taxes, check with your state to see if the rate reduction applies in your state.
State and Local Tax
Let's move into state and local tax. Unfortunately, this is different across 50 states and numerous cities across the US. I will mention the typical taxes that we expect to see here. First, we have state income tax withholding.
This is similar to federal tax withholding but it's a flat or tiered percentage in several states. However, some states have an actual withholding tax table just like the IRS. Also, in some cases, you will see a local tax levied by cities, municipalities, or counties charged to the employees as an additional income tax. This is most typically seen in larger metropolitan areas such as New York City or San Francisco.
For example, if an employee lives in San Francisco, they will also pay an additional flat 1.5% city tax on their income. Both of those I just described are at the employee level So they will see this tax in their pay stubs as a reduction of the net pay.
But there are also some typical state taxes paid by the employer. For example, we have the state unemployment tax, often referred to as SUTA, employees will not see this on their paychecks. Also, states charge additional state-level taxes to employers to fund employee benefit programs such as training or retraining programs for unemployed individuals.
All that being said, it is important to point out that most payroll software connects digitally to the taxing authorities and receives updates regarding tax rate changes. This will update the payroll system in real-time, so your payroll taxes get calculated accurately.
All these taxes I mention, whether they're being paid by the employee through a reduction of their net paycheck or incurred by the employer need to be remitted by the employer in a proper and timely manner. I'll also throw one last curveball at you. Not all gross wages are subject to tax.
For example, an employee can elect to have their health insurance paid by the employer, but their portion paid through payroll. So that portion of health insurance paid by the employee is not subject to payroll taxes. A little bit more complex is a 401-k retirement plan, because all contributions to your 401-k are not subject to federal tax, but are subject to FICA.
So as you can tell, every payroll item needs to be looked at individually to determine which tax is applied to each one. I strongly recommend my clients to use QuickBooks for their accounting with QuickBooks payroll to make all these calculations seamlessly and concentrate on doing what they love to do. There are hefty penalties for employers that do not pay, pay late, or make mistakes paying these payroll taxes.
So it's important to have a process in place to make sure these payments are made accurately and timely. Let's do a simple example. Let's say we have an employee in Florida, which doesn't charge state income tax or even local taxes, meaning that you will not see tax withholding at the state level in the employee's cheque.
This employee makes $1000 a week, so let's break it down. Mike is single and works for a Florida-based company. His gross wages are $1000 a week. In the further withholding tax table according to publication 15-T, his federal withholding would be $87. Then you can have Social Security tax for $62 which is 6.2% of the gross wages, then you will see Medicare, which is $14.50, which is 1.45% of the wages, and finally, a net paycheck of $836.50.
Now, let's see how the employer is going to accrue their portion of the tax. You're gonna see the same Social Security for $62 and Medicare, $14.50 amount as a matching portion of the FICA tax. Besides, you're gonna see the federal unemployment tax or the FUTA out for $6, which is 0.6% of the first $7,000.
You're gonna see the state unemployment tax, which happens to be 2.7% of the first $7,000, so that will be $27. So the employer paid in cash $836 in the paycheck, paid $240 to the IRS as a combination of federal withholding and FICA tax, paid $6 to the IRS in connection to FUTA, paid $27 to the state in connection to SUTA, and that's a total of $273 in taxes remitted to the government.
If you add up the net paycheck and the taxes paid, that is $1,109.50, which is a total cash outlay by the employer, which is about 10% above the actual wages. This percent will vary greatly state by state. So it is safe to estimate that the tax overhead for being an employer could vary between 8 and 15%. So if you are in a traditional employer tax-friendly state like Wyoming or South Dakota, your tax burden as an employer will vary greatly compared to states with much higher tax burdens like California or New York. For example, in California, you will need to add the following.
State disability tax, which is 1.2% of their first $128,000 in 2021, and state income tax on the employee's paycheck calculation based on their individual income tax table. The employer also needs to pay a training tax which is 0.1% of the first $7,000.
In conclusion, payroll taxes are not a walk in the park if you need to manage this manually, So we strongly recommend that firstly you have to choose the best payroll software like QuickBooks Payroll then it would feel like it is. Even after understanding all the tax laws and the procedure, it is highly recommended to hire a payroll service provider. It is a more affordable and comfortable one as you don’t need any contract or you can get professional services.