Payroll Tax vs Income Tax

If you’re starting a business and expecting to hire employees, you’ll need to understand how to navigate the complex payroll process. A key part is calculating paycheck withholdings for your employees. One critical element to understand is the difference between payroll tax and income tax, and who pays what. 

Luckily, this guide has you covered with a comprehensive explanation of these taxes and how they differ. 

What is the Difference between Payroll and Income Taxes?

As you’ll see below, both payroll and income taxes must be withheld from employee paychecks, but there are two significant differences between the two. 

• Payroll taxes fund specific government programs; income taxes go to the IRS
• Payroll taxes are paid by employer and employees; incomes taxes are paid only by employees

What Is Payroll Tax?

In a nutshell, a payroll tax is any tax withheld from an employee’s pay or paid by the employer that goes directly to fund government programs. Payroll taxes withheld from employee paychecks are to fund Social Security and Medicare, to which the employer also makes payroll tax contributions. 

The Social Security tax is paid by both the employee and the employer at 6.2% of the employee’s wages. The Medicare tax is also paid by both the employee and the employer, but at a rate of 1.45% of employee compensation.

For Social Security, there is a maximum wage limit. As of the 2022 tax year, if an employee makes more than $147,000, Social Security taxes do not have to be withheld. Medicare does not have a maximum wage limit, but any individual that earns more than $200,000 per year must pay an additional 0.9%.

Employers are also required to pay taxes under the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA). States may also have their own payroll taxes that must be paid, so be sure to check with your state tax department.

What Is Income Tax?

Put simply, an income tax is a tax placed on employee compensation by the main tax body of the local, state, or federal government. 

Income taxes are paid by the employee at the federal, state, and local levels. At the federal level, the rate depends on the employee’s tax bracket. State and local taxes may or may not have fixed rates.

How much is withheld for federal income tax depends on the employee’s W-4, which should be filled out at the time of hire. The W-4 specifies the employee’s filing status, dependents, and additional withholding requests. To calculate federal income tax withholdings, refer to IRS Publication 15. 

In states that charge income tax, and most do, employees will also fill out a state withholding form. To calculate state income tax, refer to state-specific resources. The same is true for local taxes. 

Keep in mind that using a payroll software or service can make the process much easier.