Payroll Tax

What is 'Payroll Tax'

Payroll tax is a tax that an employer withholds and pays on behalf of his employees. The payroll tax is based on the wage or salary of the employee. In most countries, including the United States, federal authorities, as well as many state governments, collect some form of payroll tax.

Governments use revenues from payroll taxes to fund programs such as Social Security, health care, unemployment compensation and workers compensation. Sometimes local governments collect a small payroll tax to maintain and improve local infrastructure and programs, including first responders, road maintenance, and parks and recreation.

BREAKING DOWN 'Payroll Tax'

The three basic line items that are taken from paychecks in the United States are Social Security, Medicare and income taxes, depending on the state.

Generally, your employer is responsible for funding unemployment, which you can draw from if you're let go or (depending on the circumstances) fired. The rate that the employer pays varies by industry and by state and federal fees. However, there are also a handful of states that require the employee to fund unemployment and disability insurance.

Federal payroll taxes cover Social Security and Medicare contributions, and the withholding is collected as the Federal Insurance Contributions Act (FICA) tax. The basic premise of Social Security and Medicare is that you pay into them while you work, and eventually you qualify to withdraw from those funds.

Deducted payroll taxes are likely to be itemized on an employee's pay stub. The itemized list typically notes how much was withheld for Medicare and Social Security payments, as well as state or municipal payroll taxes.

As of 2017, employers must take 7.65% of their employees' earnings for payroll taxes (6.2% for Social Security and 1.45% for Medicare). Employers must also match the amount withheld from their employees' checks and submit the total to the Internal Revenue Service (IRS). For example, for every $1,000 an employer pays his employee, he needs to withhold $76.50 for federal payroll taxes. Then he needs to match that amount and send the total of $153 to the IRS.

Social Security Payroll Tax

Money paid for Social Security taxes goes into two trust funds: the Old-Age and Survivors Insurance Trust Fund, which pays retirement and survivor benefits, and the Disability Insurance Trust Fund, for disability benefits. These are managed by the Secretary of the Treasury, the Secretary of Labor and the Secretary of Health and Human Services, the Commissioner of Social Security and two public trustees. Current workers help pay for the benefits that seniors, those who are disabled and survivors are receiving.

As of 2017, employers only need to withhold Social Security payroll tax on the first $127,200 that their employees earn.

When President Franklin D. Roosevelt presented his plan for Social Security in 1935, it did not include an income cap. The original plan exempted high earners from Social Security altogether -- including both taxes and benefits -- and anyone who made more than $3,000 a year (about $54,000 in 2017 dollars) was supposed to be left out of the system completely.

As FDR's plan worked its way through Congress, the exemption for high earners was eliminated, and the House Ways and Means Committee replaced it with a $3,000 cap. Historians have found no evidence supporting why the committee chose an earnings cap over an exemption, but it has been in place ever since the Social Security Act was signed into law in 1935. Since 1982, the earnings cap has risen at the same rate as wages in the economy.

The cap on wages subject to the tax is the subject of controversy, in part because it means that while most workers pay the tax on every dollar of their income (because the vast majority of workers earn less than the wage base limit), the highest earners pay tax on only a portion of their income. Proponents of lifting the cap say it would result in a significant amount of revenue that could help cover the shortfall Social Security will soon face, while opponents claim it would result in one of the largest tax increases of all time.

Medicare Payroll Tax

There is no salary cap for Medicare tax, and a 0.9% Medicare surtax is withheld from the employee when wages exceed a certain amount depending on their filing status.

Money paid for Medicare taxes goes into two trust funds, the Hospital Insurance Trust Fund and the Supplementary Medical Insurance Trust Fund. The Hospital Insurance Trust Fund pays for Medicare Part A and the resulting administration fees. The Supplementary Medical Insurance Trust Fund pays for Medicare Parts B and D, and other Medicare program administration costs.

Self-Employment Taxes

Individuals who are self-employed, including contractors and small business owners, do not have employers to remit payroll taxes on their behalf. As a result, they must pay their own payroll taxes. These taxes are called self-employment taxes, but they function like payroll taxes.

As of 2017, self-employed individuals must pay 12.4% of their earnings in Social Security contributions and 2.9% in Medicare payments for a total of 15.3% on the first $127,200 in net income. The 0.9% Medicare surtax also applies to self-employed people making over a certain amount of money.

Payroll Taxes vs. Income Taxes

Payroll taxes are specific taxes used for specific programs, and they are distinct from income taxes, which are put into the government's general fund. While everyone pays a flat payroll tax, income taxes are progressive, and rates vary based on earnings. Employers do not match income taxes, and self-employed individuals do not face higher income taxes than other workers.

Federal income tax is paid into the U.S. Treasury. State income tax, if you live in one of the 43 states that has it, goes into the state's treasury.