Taxes can be difficult to understand at times, especially when you are trying to set up your own business. A good business runner needs to be handy at a bunch of things, a real jack of all trades.
But taxes can be a hurdle where a lot of budding entrepreneurs can trip and stumble and not all of them can afford to pay an expert to do the work for them.
If you are struggling to understand what payroll and income taxes are, what the difference is and what you need to pay, then here is what you need to know regarding payroll and income taxes so you can run your business without struggling beneath this business tax burden.
Use the information below to know which tax you have to withhold as the employer, and how to calculate both.
What Are Payroll Taxes?
Payroll tax consists of Social Security tax and Medicare taxes – also known as Federal Insurance Contribution Act tax (FICA). FICA tax is a tax both the employer and the employee have to pay, so you and your employees must contribute towards it.
This means that it is a percentage that you as the employer withhold from your employee’s wages – and you have to contribute the same amount. So, if an employee pays thirty dollars in payroll tax, you as the employer must also contribute thirty dollars for the employer portion towards the tax.
Payroll tax is also a flat rate tax, so the same tax rate applies to every taxpayer regardless of income.
What Are Income Taxes?
Income tax is made up of state, local income, and federal taxes, and are paid solely by the employee. The federal tax is paid by every employee unless they are exempt.
Some states like West Virginia and New York also have an additional state income tax, and some localities also have their own local income tax too. These are all paid under income tax.
Income tax uses a progressive tax rate.
What Is The Difference Between Payroll and Income Taxes?
The main difference between these taxes is who pays it. Payroll taxes are paid by both the employers and the employee, while the income tax is only paid by the employee.
However, businesses are responsible for withholding both payroll and income taxes, so it is the employers responsibility to withhold these taxes when making payroll.
Another difference between payroll and income taxes is that they affect employees differently. Income taxes are progressive, so those who earn more end up paying more as they can afford to.
Payroll taxes, however, are regressive – meaning that the more you earn, the lower the percentage of your salary will end up as payroll tax.
They also fund different things. Payroll tax goes towards Social Security and Medicare programmes, so the tax pays for services like retirement, health care, and disability. Income tax funds public services like education and transport through federal tax.
How To Calculate Payroll Tax
To calculate the payroll tax you and the employer must pay, you have to know the current FICA tax rate. This can always change annually due to inflation, so it is best to check it before calculating payroll.
Both employers and employees currently pay a rate of 6.2% towards social security tax. This is only for the first $142,800 of earnings. Then, both must also contribute a further 1.45% to Medicare.
There is also an additional 0.9% on earnings over $200,000 for single filers and $250,000 for joint filers. However, this additional tax does not apply to employers.
Add all this up together, and you get the FICA tax rate – currently sitting at 7.65%. Work out how much of your employees wages you withhold with this rate, and then you as the employer must contribute the same amount.
How To Calculate Income Tax
Income taxes are what fund government spending, and can be imposed at different levels. Only nine states do not tax employee incomes – Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. If you are an employer outside of these states, then you will have to calculate the state tax as well.
As an employer, you will use the employee’s W-4 form to calculate the amount of federal income tax to withhold from their wages.
To help with this, employers can also refer to the IRS Publication 15 – Circular E. If your employee also has to pay state or local income taxes, your employee will have to submit a withholding form.
If your employee also has sources of income outside of the wages you supply, then it is their responsibility to pay income taxes on those sources. You, as their employer, are only responsible for withholding the taxes on the income you provide.
If your employee also has additional income from bank interest or dividends, then they are ones responsible for paying the tax on those.
Paying the correct amount of tax is vital to our society, as it funds so much of our community services. This is why calculating taxes is important to know and understand when running your own business – you could end up in hot water if you calculate the wrong amount or fail to withhold the taxes.
There are software programs available to help you calculate how much you need to withhold from your employee’s wages for tax purposes, and this will help you minimize any mistakes and save you a lot of time.
You can always do payroll by hand, but this leaves you vulnerable to mistakes and doing so can take up a lot of your time.
But whichever way you decide to do your payroll – either by yourself or with a software or by hiring someone else to do it all for you – at least you now know what payroll and income taxes are, their differences, and how they affect you as an employer and your employees.