What's the difference between payroll and income taxes?

If your business issues paychecks, you need to withhold various federal, state and local taxes for the government. Payroll tax and income tax are the most common employment taxes. Understanding the differences between them and making sure you manage withholding properly are two of the most important parts of payroll management.

What is payroll tax?

"Payroll tax," refers to the taxes used to fund Social Security and Medicare. You may hear this called FICA, which stands for Federal Insurance Contributions Act, the law that created payroll taxes. These taxes are different from most other federal taxes because both the employer and employee pay the same amounts.

How to determine how much payroll tax to withhold

Here's how it breaks down:

• Social Security. Each employee pays 6.2% of their paycheck, and the employer matches the tax for each employee. A cap sets a maximum for social security taxes; any earnings above $142,800 (as of 2021) are not subject to social security tax.
• Medicare. The employer and the employee each pay 1.45% of the employee’s gross salary into Medicare, the government health care system that covers most retired workers. Employees who make more than a certain amount ($200,000 for a single person, or $250,000 for a married couple filing jointly) pay an additional 0.9% in payroll taxes; employers don't have to match the added 0.9%. The combined total rate that both employer and employee pay in FICA taxes is 15.3% of gross wages. Employers must withhold this amount from every paycheck and pay it to the government by the required due date.

What is income tax?

Income tax is money taken from an employee's wages. The federal government, most state governments and some local governments collect income taxes to fund their programs. The Internal Revenue Service sets the laws and rules for how federal income tax is calculated and collected. Each employee pays a different amount of income tax depending on their personal elections and wages earned. As a business, you don't actually pay this tax for your employees, but you are required to withhold it from their pay and remit it to the IRS or the applicable state or local tax authorities.

This government database lists the state and local governments that currently collect income taxes.

How do you determine how much income tax you should withhold?

Your employees make a lot of the decisions here. They'll use Form W-4 to decide how much they want to have withheld, based on their household and personal financial circumstances. You'll need every new worker to fill out a Form W-4; then, you can use that information and the employee's earnings to calculate how much tax to deduct.

Even though you're not paying the employee’s tax for them, it is important to manage the withholding correctly and ensure that the proper amount is sent to the IRS. Check out the IRS's Publication 15, Employer's Tax Guide, for more information about payroll and income taxes and your responsibilities as an employer. You can also use the online Tax Withholding Assistant tool on the IRS website to help you create a spreadsheet that calculates the right amount of federal income tax to deduct for each employee.

Best practices for filing payroll and income taxes

Whether you manage it yourself, have a staff member to help or outsource the task, it's important to put enough resources into tax compliance to do it right. Errors in determining the amount owed, or delays in making payments or filing returns, could lead to fines and other financial penalties that your business can't afford. Small-business owners can ensure that their business expenses remain manageable and their taxes are paid on time with these best practices:

1. Enlist the help of experts. Even if you plan to manage payroll in-house, it can be helpful to have an accountant or other tax professional assist you with setting up your records and calculating withholding, especially for salaried workers. Then, use the right accounting software to help keep yourself organized.
2. Create pay stubs for each employee. Pay stubs show an employee's gross wages, income and payroll taxes withheld, and the net amount they are paid. Having these detailed records makes it easier for you and your workers to file tax returns and other paperwork.
3. Follow federal and state regulations when payments are due. Find Employment Tax Due Dates, including which forms must be filed by what dates and when tax payments must be deposited. Keep a calendar of federal, state and local deadlines to avoid missing a payment and the resulting penalties.

Understanding your tax responsibilities helps protect your business and the people you rely on the most: your team. Opening a business checking account or using other business services can also help you stay on top of your finances.