Odds are, if you somehow happened to pull out your most recent pay stub, you would see two significant lines among the list of taxes removed from your wages: FICA and MEDFICA. If you somehow managed to figure it out, these two lines, representing the Federal Insurance Contributions Act and Medicare Federal Insurance Contributions Act individually, take up 7.65 percent of your wages.
Nonetheless, with regards to these payroll taxes as they are normally known, there is much more that is left undiscovered. The article will explore payroll taxes in-depth, how does payroll tax works, who pays it, and how to calculate it.
Table of Contents
What are Payroll Taxes?
In simple words, payroll taxes are taxes paid on the wages and salaries of employees. These taxes are utilized to finance social insurance programs, such as Social Security and Medicare. As per recent Tax Foundation research, these social insurance taxes make up 23.05 percent of combined federal, state, and local government revenue – the second highest source of government revenue in the United States.
The biggest of these social insurance taxes are the two federal payroll taxes, which appear as FICA and MEDFICA on your pay stub. The first is a 12.4 percent tax to fund Social Security, and the second is a 2.9 percent tax to fund Medicare, for a combined rate of 15.3 percent. Half of the payroll taxes (7.65 percent) are paid directly by employers, while the other half (7.65 percent) are removed from workers’ paychecks.
Who Really Pays Payroll Taxes?
Possibly one of the top-kept secrets of payroll taxes is that employees successfully pay almost the entire payroll tax, rather than dividing the liability with their employers. This is on the grounds that tax incidence is not controlled by law, however by markets. In fact, the individual who is needed to pay a tax to the federal government is often different than the person who carries the tax burden. Typically, the marketplace determines how the tax burden is split between buyers and sellers, depending on which party is more receptive to changes in prices.
It turns out that the supply of labor – that is, workers’ readiness to work – is much less sensitive to taxes than the demand for labor – or employers’ willingness to employ. This is because workers who want a job are not as quick to respond to changes in wages, but businesses are able to “shop around” for the finest workers or shift production to different locations.
Payroll Tax Cut Explained
Payroll taxes along with income taxes are gathered by federal authorities and some state governments in many countries, including the United States. These payroll tax deductions are listed on an employee’s pay stub. The itemized list takes note of how much is withheld for federal, state, and municipal income taxes as well as the amounts collected for Medicare and Social Security payments.
Governments make use of revenues from payroll taxes to finance specific programs including Social Security, healthcare, and workers’ compensation. Local governments may collect a somewhat small payroll tax to sustain and enhance local infrastructure and services, including first responders, road maintenance, and parks.
Employers have the main responsibility for financing unemployment insurance. If they lay off employees, those employees are eligible for unemployment benefits. The rate of unemployment insurance the employer will incur varies by industry, state, and federal fees. Some states need employees to donate to unemployment and disability insurance.
Federal payroll taxes cover Social Security and Medicare contributions, which represent the Federal Insurance Contributions Act (FICA) tax. An employee pays 7.65%. This rate is divided between a 6.2% deduction for Social Security on a maximum salary of $137,700 and a 1.45% share for Medicare.
There is no salary restriction on Medicare, but anyone who makes more than $200,000—or $250,000 for married couples filing jointly—pays another 0.9% for Medicare.
The idea of Social Security and Medicare is that you pay into them during your working years in order to be eligible for withdrawing these funds after retiring or under specific medical circumstances.
Employees pay 6.2% into Social Security for the first $132,000 earned, and another 1.45% into Medicare on all wages.
Self-employed individuals including contractors, freelance writers, musicians, and small business owners are also obliged to pay payroll taxes. These are referred to as self-employment taxes.
Dissimilar to most salaried workers, people who are self-employed don’t have employers to pay payroll taxes on their behalf. This means they have to cover both the employer and employee portions of the tax on their own.
The self-employment tax rate is 15.3%. There are two parts to this rate including a 12.4% contribution to Social Security—old-age, survivors, and disability insurance—and a 2.9% payment to 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 lead to two trust funds: the 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 handle these trust funds.
President Franklin D. Roosevelt initiated the Social Security Act into law on Aug. 14, 1935, to offer a safety net for the disabled and retirees. In the original concept of the program, high-wage earners were excused from paying into the fund and from receiving Social Security benefits. But that exemption was removed and replaced with a cap by Congress which has continued to rise nearly at the same rate as wages.
Medicare Payroll Tax
As mentioned above, payroll taxes also head 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 related 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 helps 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 costs.1Part D helps with prescription drugs.
Individuals registered in Medicare pay a monthly income-based fee for basic Medicare coverage and are accountable for a portion of their medical costs
When does it start?
On Aug. 28, the IRS issued Notice 2020-65, permitting employers to halt withholding and paying to the IRS eligible employees’ Social Security payroll taxes, as part of COVID-19 relief.
The payroll tax “holiday,” or suspension period, runs from Sept. 1 through Dec. 31, 2020, and is applicable only for employees whose wages are less than $4,000 for a biweekly pay period, as well as salaried workers earning less than $104,000 per year.
Companies that suspend collection of employees’ payroll tax would collect additional amounts from workers’ paychecks from Jan. 1 through April 30 next year to repay the tax obligation.
President Donald Trump sent a memorandum on Aug. 8 to the Treasury Department to defer collection of the employee portion of Social Security from Sept. 1 through the end of 2020.
Did the payroll tax cut pass?
Although the president’s other executive acts are legally disputed in respect to whether they’re unconstitutional, the payroll tax holiday is within Trump’s executive powers, according to Jacoby.
Senate Democrats seem to have figure out a way to maybe reverse Trump’s tax holiday. A
letter sent on Sept. 2 to the Government Accountability Office (GAO) from Senate Minority Leader Chuck Schumer, a Democrat from New York, and Sen. Ron Wyden, a Democrat from Oregon, requests the office to decide if the assistance provided for the payroll tax holiday could be viewed as a “rule.”
Under the Congressional Review Act, Congress can reject a rule that’s already in effect, and if successful in this case, it could put an end to the payroll tax holiday.
According to the senator’s execution of this Treasury and IRS guidance will lead to significant, material consequences for workers starting early next year – particularly lower and middle-income earners — whose employers elect to temporarily defer the employee portion of those payroll taxes.
Payroll Taxes vs. Income Taxes
There is a difference between a payroll tax and an income tax, even though both are deducted from paychecks. Payroll taxes are used to finance particular programs. Income taxes go into the general funds at the U.S. Treasury.
Everyone pays a flat payroll tax rate, up to a yearly cap. Income taxes, on the other hand, are progressive. Rates vary according to an individual’s earnings.
Payroll Tax Cut Calculator
The White House rolled out a web tool that lets every single American to find out how much extra money will be in their pockets if Congress passes the American Jobs Act, and how much their taxes will go up if Congress fails to act. You can view the tool here: http://www.whitehouse.gov/economy/jobsact/calculator
Payroll taxes are an essential component of America’s system of taxation and they fill an important role in maintaining social insurance programs funded and operational. Payroll taxes represent the second-largest source of federal revenues, after income taxes. On the household level, payroll taxes are every so often the primary federal tax an individual will be required to pay; in fact, nearly two-thirds of households pay more in payroll taxes than income taxes, according to the Tax Policy Center.
Social insurance programs, mainly Social Security and Medicare, face serious financial crises. Those challenges will likely increase due to the drop in economic activity and payroll tax revenues affected by the COVID-19 pandemic and legislation in response to it. Understanding how programs are funded through payroll taxes is crucial for building reforms that will make sure that those programs can continue to provide benefits to the recipients who depend on them.