What Is a Payroll Tax?

A payroll tax is a tax withheld from an employee's salary by an employer who remits it to the government on their behalf. The tax is based on the wages, salaries, and tips paid to employees. Payroll taxes are deducted directly from the employee's earnings and paid directly to the Internal Revenue Service (IRS) by the employer. In the United States, payroll taxes are divided into three main categories: Federal income, Medicare, and Social Security. The government also collects money for federal unemployment programs.

Key Takeaways

  • A payroll tax is withheld by employers from each employee’s salary and is paid to the government.
  • Self-employed individuals pay the government self-employment taxes, which serve a similar function.
  • Payroll taxes are used for specific programs; income taxes go into the government’s general fund. For example, Social Security and Medicare taxes go into specific trust funds.

How Payroll Taxes Work

Payroll taxes are collected by federal authorities and some state governments in many countries including the United States. These payroll tax deductions are normally itemized on an employee's pay stub. This itemized list typically notes how much is withheld for federal, state, and municipal taxes, as well as any collected for Medicare and Social Security payments.

Governments use revenues from payroll taxes to fund specific programs such as Social Security, healthcare, 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.

An employer is generally responsible to fund unemployment insurance. If qualified, a former employee can access these funds upon termination of employment. The rate of unemployment insurance the employer will pay varies by industry, state, and federal fees. However, there are also some states that require the employee to contribute to unemployment and disability insurance.

Federal payroll taxes cover Social Security and Medicare contributions, which constitute the Federal Insurance Contributions Act (FICA) tax. Employees deductions amounted to 7.65% as of 2019. This rate is divided between a 6.2% deduction for Social Security on a maximum salary of $132,000, while the other 1.45% goes to Medicare. There is no salary limit on Medicare, but anyone who earns more than $200,000—$250,000 for married couples filing jointly—pays another 0.9% for Medicare.

The basic premise of Social Security and Medicare is that you pay into them while you work. You may qualify to withdraw from these funds after you retire or, if you meet certain medical circumstances.

Employees pay 6.2% for Social Security for the first $132,000 earned, and another 1.45% for Medicare on all wages.

Special Considerations

Self-employed individuals including contractors, freelance writers, musicians, and small business owners are also required to remit payroll taxes. These are referred to as self-employment taxes and function just like payroll taxes. Unlike most salaried individuals, people who are self-employed don't have employers remit payroll taxes on their behalf. This means they must cover both the employer and employee portions of the tax on their own.

The self-employment tax rate was 15.3% as of 2019 and is similar to employees who have payroll taxes deducted from their salaries. There are two parts to this rate including a 12.4% contribution that goes toward Social Security—old-age, survivors, and disability insurance—and 2.9% for Medicare. Another 0.9% surtax for Medicare applies to self-employment earnings that exceed $200,000.

Social Security Payroll Tax

Funds paid to Social Security taxes go into two trust funds: Old-Age and Survivors Insurance Trust Fund (OASI), which pays retirement and survivor benefits, and the Disability Insurance Trust Fund, for disability benefits. The Secretary of the Treasury, the Secretary of Labor, the Secretary of Health and Human Services, the Commissioner of Social Security, and two public trustees manage these trust funds. 

President Franklin D. Roosevelt signed the Social Security Act into law on Aug. 14, 1935, to provide a safety net for the disabled and retirees. In the original conception of the program, high-wage earners were exempt from paying into the fund and from receiving Social Security benefits. But that exemption was eliminated and replaced with a cap by Congress, and has continued to rise by the same rate as wages.

Medicare Payroll Tax

As noted above, payroll taxes also go toward Medicare. These payroll deductions go into two separate 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 associated administration fees. Part A assists in covering hospital care, skilled nursing inpatient care, and, in some cases, home care. 
  • The Supplementary Medical Insurance Trust Fund assists in paying for Medicare Parts B and D and other Medicare program administration costs. Part B covers laboratory tests and screenings, outpatient care, x-rays, ambulance service, and many other items. Part D helps with prescription drugs.

Individuals enrolled in Medicare may also have to pay a portion of their medical fees at the time of use, as well as income-based fees to Medicare.

Payroll Taxes vs. Income Taxes

Payroll taxes, which are used to fund specific programs, are distinct from income taxes. Individuals are taxed at both the federal and state levels. In some cases, municipalities may also impose local taxes. Income taxes are put into the government's general fund at the U.S. Treasury. While everyone pays a flat payroll tax, income taxes are progressive which means rates vary based on an individual's earnings. State income tax, if applicable, goes into the state's treasury.