Understanding Payroll Taxes

Taxes are a very complex topic and understanding the basics of how the tax system works in the United States will help you understand the nature of the system. The overall tax system is pretty complex and the government literally has hundreds of thousands of pages which describe the rules and regulations we must follow.

In this tutorial, we’re going to explore payroll taxes and federal income tax withholding. Through the use of examples, we will show you how the tax system works and how you contribute to the operation of the United States government.

In this tax tutorial, you will learn about payroll taxes and income tax withholding. Basically, the tax personal income tax withholding system works with these components:

  • Employers withhold payroll taxes and income tax from employees’ pay.
  • Employers send the amounts withheld to the federal government.
  • Employees complete Form W-4.
  • Employers use Form W-4 to determine how much income tax to withhold from employee pay.

Social Security Taxes

The Social Security tax is also called the FICA (Federal Insurance Contributions Act) tax. Social Security arrived in the United States in 1935 as a social insurance to help those who did not save throughout their life to be provided for by other wage earners. Social Security taxes provide the following benefits for employees and their dependents:

  • retirement benefits
  • benefits for the dependents of retired workers
  • benefits for the disabled and their dependents

Medicare Tax

The Medicare tax is used to provide medical benefits for certain individuals when they reach age 65. Workers, retired workers, and the spouses of workers and retired workers are eligible to receive Medicare benefits upon reaching age 65.

What Do Federal Income Taxes Pay For?

There are countless programs and agencies that you tax dollars pay for.

Federal income taxes finance:

  • national defense, veterans, and foreign affairs
  • social programs
  • physical, human, and community development
  • law enforcement
  • interest on the national debt

The federal tax system is based on employer withholding from an employee’s paycheck. Employers withhold taxes from employees’ pay. The tax rates are based on the income bracket the employee is in, how many deductions they claim, and other factors.

  • Gross pay is the amount the employee earns.
  • Net pay, or take-home pay, is the amount the employee receives after deductions.

The difference between gross pay and net pay is:

  • Social Security taxes
  • Medicare taxes
  • income tax withheld
  • other amounts withheld

Employers send the withheld taxes to the taxing authorities. At the end of each tax year, the employee completes a tax return to calculate whether or not they paid enough taxes throughout the year. If they have not paid enough taxes, the must send additional money to the government. If they have paid too much, the taxpayer receives a refund of the taxes overpaid throughout the year.

Payroll Tax Rates
Social Security tax rate 6.20%
Medicare tax rate 1.45%
Total payroll taxes 7.65%

If an employee earns $1,000, the payroll taxes are:

Social Security tax $62.00
Medicare tax $14.50
Total payroll taxes $76.50

The employer sends the $76.50 to the federal government.

There is a maximum annual amount of Social Security tax withheld per employee. Social Security taxes are not withheld on amounts over the earnings limit. For 2009, the earnings limit was $106,800, and the maximum Social Security tax was $6,621.60 ($106,800 x 6.2%). There is no limit on the amount of wages subject to Medicare tax.

The Employee W-4 Form

Employees complete Form W-4, Employee’s Withholding Allowance Certificate to determine how much federal income tax to withhold.

The amount of federal income tax withholding depends on

  • the employee’s marital status,
  • the number of withholding allowances claimed by the employee,
  • any additional amount the employee wants to withhold, and
  • any exemptions from withholding that the employee claims.

An Example W-4

Review Form W-4 for Alicia Myers. Notice that Alicia is single and claims one withholding allowance.

Angela Viviano earns $2,000 a month as a physical therapist’s assistant. In addition to payroll taxes and income tax withholding, her employer withholds $50 for her retirement account. Angela’s net pay is calculated as follows:

Gross pay $2,000.00
Social Security tax (6.2 percent of gross pay) -$124.00
Medicare tax (1.45 percent of gross pay) -$29.00
Income tax (per Form W-4) -$220.00
Retirement -$50.00
Net pay $1,577.00

Angela earns $2,000 and receives $1,577.

Her employer sends $373 ($124 + $29 + $220) to the federal government and $50 to the retirement fund.

Federal Income Tax Withholding

  • Employees complete Form W-4.
  • Employers use Form W-4 to determine how much income tax to withhold from an employee’s pay.
  • Employers withhold payroll taxes and income tax from employees’ pay.
  • Employers send the amounts withheld to the federal government.

Federal income taxes are a complex topic. In this tutorial, we learned about how payroll withholding works and how employees pay into the federal government.