Payroll tax vs. income tax: Understanding the differences

Taxes are essential. They fund our schools, roads, and government agencies. But they can also be incredibly complex and intimidating.

Although we file taxes every year, they still seem impossible to figure out. Understanding the distinction of payroll tax versus income tax is a great place for employers and employees to start. Although both impact paychecks, payroll and income taxes have different purposes and calculations.

Here, we’ll explain the key differences between these taxes, explaining who pays them, how they’re calculated, and the employer’s responsibilities.

What is payroll tax?

Payroll taxes, also known as employment taxes, are taxes paid by an employee and their employer to fund federal and state programs. In the United States, these programs include Social Security, Medicare, and unemployment insurance. The amount owed is a percentage of the employee’s payment.

Often confused with income tax, payroll tax exclusively funds the above programs and only applies to wages and salaries.

How to calculate payroll taxes

How much an individual pays into social programs depends on how much they earn. Each program has a different rate, which is set every year. In 2024, the U.S. rates were as follows:

• Social Security: 6.2% on the first $168,000 wages. This rate is paid by both the employee and the employer.
• Medicare: 1.45% paid by the employee and the employer, plus another 0.9% for wages above $200,000.
• Federal Unemployment Tax Act (FUTA): 6% on the first $7,000. The employer pays this, but it effectively drops to 0.6% if the employer receives the maximum unemployment tax credit of 5.4%. So, the most an employer would pay per employee in 2024 is $42.
• State unemployment insurance (SUI): State unemployment insurance taxes vary by state and may be a flat rate or a percentage.

Payroll tax example scenario

Consider an employee in the U.S. who makes $15,000 a year and files singly in 2024. In this example, we’ll calculate their Social Security, Medicare, and FUTA taxes:

• Social Security tax: The Social Security tax rate is 6.2% for both employees and employers (or 12.4% for self-employed individuals) up to the $168,600 wage base limit. Therefore, the employee’s Social Security tax would be $15,000 × 0.062 = $930.
• Medicare tax: The Medicare tax rate is 1.45%, with no wage limit. Their Medicare tax is $15,000 × 0.0145 = $217.50
• FUTA tax: The FUTA tax rate is 6% up to the $7,000 wage base limit, making their FUTA tax equivalent to $15,000 × 0.06 = $900

The employee is responsible for Social Security and Medicare taxes, whereas their employer must pay all three. In this scenario, the employee’s total payroll tax amount is $1,147.50, and the employer owes $2,047.50.

What is income tax?

Workers pay income taxes at the federal and sometimes state and local levels (several states, including Alaska, Florida, and Texas, don't have income tax). Most citizens and legal residents must pay income tax on all sources of income, not just wages. The amount paid depends on the tax rates, gross wages, and withholdings listed on their W-4 form. This form reflects filing status and dependents, lowering taxes for people supporting children. 

Only workers pay income tax, but employers must deduct it from their employees’ incomes. The government uses the money from income taxes for more general funding than payroll taxes. State income taxes are common, but local income taxes are more unusual.

How to calculate income tax

U.S. federal income tax is more complicated to calculate than payroll taxes. It involves withholding tables, standard deductions, wage brackets, exemptions, and pay frequency.

Let’s look at another example taxpayer. Assume they have $58,000 in taxable income after deductions. We’ll consider their federal income tax but ignore state taxes for this example, which can vary from 0% to 13.3%.

We’ll consult the tax rate table to calculate how much they owe. Here are the 2023 tax brackets for single payers:

Source: IRS Federal income tax rates and brackets

Fortunately for this employee, each rate only applies to the part in that bracket. So, their first $11,000 is taxed at the lowest rate: 10%. Their earnings between $11,001 and $44,725 are taxed at 12%. Only the final portion of their $58,000 is taxed at 22%.

Here’s how to calculate the federal income tax the employee will owe:

$11,000 × 0.1 = $1,100

($44,725 − $11,000) × 0.12 = $4,047

($58,000 − $44,725) × 0.22 = $2,920.50

Total = $1,100 + $4,047 + $2,920.50 = $8,067.50

What are the differences between payroll tax and income tax?

Both income and payroll taxes are deducted from workers’ paychecks each pay period, so how are they different?

Income and payroll taxes have a lot in common. Both are paid to governments to fund programs, and both factor in various deductions.

Employees who elect to make voluntary deductions will have more withheld from each paycheck. However, the extra deductions support the worker directly, as with health insurance, vision insurance, HSA or FSA plans, and retirement.

If you’re still unsure who pays income tax and who pays payroll tax, that’s all the more reason to invest in an excellent payroll system that can handle it for you.

Best practices for processing payroll and income taxes

Taxes are something you want to get right the first time. Given the necessity of taxes and the penalties for not paying them, you must ensure that they’re processed and paid accurately. When setting up a new payroll system, be sure to always:

• Categorize employees and independent contractors: Your company is responsible for different taxes depending on whether workers are classified as employees or independent contractors. Classifying all workers as contractors is tempting because it lowers the employer’s tax burden, which is why the penalty for misclassification is so steep. Follow the IRS guide (or relevant state guidelines) when categorizing your workers.
• Consider voluntary deductions: Employees can (and usually do) elect to have additional amounts withheld when offered benefits. These may contribute towards retirement, healthcare, or union costs.
• Complete payroll forms: You must complete each payroll tax form, no matter how complicated it seems. This includes forms 941 and 940 for federal taxes, form W-3 for withholding reporting, and form 1096 for any independent contractors.

Follow these guidelines closely when you create your payroll breakdown. The size of your team and how much they owe individually will determine how much you need to withhold in total taxes. Use a yearly payroll breakdown form to ensure you remit the correct amount when taxes are due each year.

Global payroll compliance

Global companies must keep track of multiple tax rates, deadlines, classifications, and worker regulations. The rules laid out above apply to taxes in the U.S., but you must ensure global payroll compliance if your team is distributed worldwide. Be sure to research the laws of all relevant countries, as well as all regional regulations.

What do payroll and income taxes pay for?

The U.S. government reports its annual spending so the public can see where their money is going. It spent $9.3 trillion in the 2023 fiscal year, and the vast majority of that money came from income and payroll taxes. Here is a breakdown of the biggest expenditures:

1. Medicare: 16.7%
2. Social Security: 15.4%
3. National defense: 13.9%
4. Health (e.g., healthcare services and research): 11.1%
5. Net interest (e.g., interest on Treasury debt securities): 9.7%
6. Income security (e.g., food, disability, and housing assistance): 8.9%

The rest was split between education, transportation, natural resources and agriculture, law enforcement, and other spending.

Simplify payroll and taxes in your company

Taxes are famously complicated and tedious. But they don’t have to be. A qualified professional can handle it for you, and you can ensure proper documentation with a comprehensive payroll system.

Oyster is a global employment platform that handles payroll processing so you can focus on growing your business. Run payroll compliantly with 99% accuracy, automate tasks like invoices and reimbursements, and gain valuable insights with instant payroll reports.

Discover how Oyster can simplify your global payroll operations and ensure compliance for your international team. Book a demo today.

About Oyster‍

Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.

Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.