Nearly every individual and business in the United States has to deal with payroll and income taxes in one way or another. They can overlap in confusing ways as well, but several key distinctions set them apart from each other.
1. Payroll and Income Taxes Are Counted Differently
While income and payroll taxes can seem almost identical, they are counted in distinct ways. Payroll taxes are calculated at a flat rate as a percentage of an employee's wages. It's less about the individual employee and more about the payroll itself.
Income taxes, however, are concerned with businesses and private individuals in terms of their entire income, which can include money from a wide range of sources and not just a company payroll. Calculating income tax not only requires adding up someone's annual income but also considering their tax credits, deductions, filing status, and specific tax brackets.
2. Payroll and Income Taxes Are Structured Differently
The different process for calculating these taxes reflects their different structure. Income taxes in the U.S. are progressive taxes. This means that the percentage of the tax taken increases as the income itself increases. With a higher income level, portions of your income will fall under tax brackets that take a much larger proportion of the money.
On the other hand, payroll tax is a regressive tax. They are taken as a flat rate according to an employee's wages until they hit a cap. Once an employee has been paid more than a set amount, they are no longer required to pay more payroll tax that year. In 2020 that set amount was $137,000.
Payroll taxes function as a regressive tax because they effectively take a lower percentage of your income as your income increases. As your income increases beyond the payroll tax cap for that year, your payroll taxes' relative size decreases.
3. Payroll and Income Taxes Are Paid Differently
Because payroll taxes are counted when wages are paid, they are paid then as well. Employers pay a portion of it, and they take the rest out of the employee's wages. Individuals and businesses will have to prove on their tax returns that they have paid their fair share, but their entire share of payroll taxes should be processed by the employer at the time.
This is subtly different from the process for paying income taxes. Employers can and should withhold a portion of an employee's income to pay income taxes, but this depends on their will. Employees fill out a W-4 to request that the business withholds income to make income tax payments.
Income tax payments made in this way are essentially estimated payments made on the employee's behalf and at the employee's request. It is up to the employee to ensure that adequate payments have been made by filing their personal tax return.
Self-employed individuals will have to quickly learn to manage both sides of this labor division between the employer and the employee. If you're self-employed, you will have to handle estimated quarterly tax payments of both your income and your payroll taxes. You will end up paying higher payroll taxes as well, as you will be responsible for both the employer's and the employee's portion.
4. Payroll and Income Taxes Go to Different Places
One of the biggest distinctions between payroll and income tax is that a payroll tax goes toward funding a specific government service or program. In contrast, income taxes go directly into general government funding.
The most prominent payroll taxes are the federal Social Security and Medicare taxes. If you're an employee of a business in the U.S., a portion of your paycheck goes to support these programs.
Many states and municipalities also have payroll taxes that support programs like unemployment insurance or local services like public transportation. Most states also levy income taxes, which go toward general government spending.
Staying in Control
It's important to stay on top of your tax obligations and ensure you understand all of your responsibilities. You don't want to pay any more than you strictly have to, but you also don't want to get in trouble or attract an audit.
If you're uncertain about handling your own personal taxes or those of a business, don't hesitate to seek out an expert. An accountant can help you understand how the system works and how to meet your responsibilities. When the stakes are high, you don't want to take unnecessary risks.