What You're Computing and Why

Payroll taxes are the amounts withheld from an employee's paycheck and the amounts an employer pays on top of wages. When you compute payroll taxes, you're calculating three main pieces: federal income tax withholding, Social Security tax (6.2% of wages), and Medicare tax (1.45% of wages). The employer matches the Social Security and Medicare portions and also pays federal unemployment tax (FUTA) and state unemployment tax (SUTA) based on the total payroll.

The math itself is straightforward once you know the rates and the gross wage. The harder part is knowing which rate applies to which employee in which pay period, because the federal withholding rate depends on the W-4 form the employee filed, and state withholding depends on where the employee works and lives.

Key Takeaways

  • Social Security tax is always 6.2% of gross wages up to an annual wage cap (which changes yearly), and Medicare tax is always 1.45% with no cap.
  • Federal income tax withholding depends on the employee's W-4 form, pay frequency, and gross wage — use the IRS withholding tables or the IRS tax withholding estimator to find the correct amount.
  • The employer pays a matching 6.2% Social Security tax and 1.45% Medicare tax, plus FUTA at 6% on the first $7,000 of each employee's annual wages (reduced by state unemployment tax credits).
  • State income tax and unemployment tax rates vary by state and sometimes by industry, so you must check your state's tax agency for the correct rates and wage bases.
  • Payroll software or a payroll service handles these calculations automatically, but understanding the steps helps you catch errors and know what you're paying.

Computing Employee Withholding: The W-4 and Federal Income Tax

Federal income tax withholding starts with the employee's Form W-4, which they file when hired and can update anytime. The W-4 tells you how many withholding allowances the employee claims and whether they want extra withholding. The IRS publishes withholding tables each year that show you the amount to withhold based on the employee's gross pay, pay frequency (weekly, biweekly, monthly, etc.), and filing status.

To use the tables: find the row for the employee's gross pay range, then move across to the column for their withholding allowances. The number in that cell is the federal income tax to withhold. If the employee requested extra withholding on their W-4, add that amount to the table result. The IRS also offers a tax withholding estimator tool on its website that can help you verify the amount, especially if the employee has multiple jobs or significant non-wage income.

The withholding tables change each year because tax brackets and standard deductions shift. You must use the current year's tables; using last year's tables will cause under- or over-withholding. The IRS publishes new tables in late fall for the following year.

Computing Social Security and Medicare Taxes

Social Security and Medicare taxes are the easiest to compute because the rates never change and the math is simple multiplication. Social Security tax is 6.2% of the employee's gross wages, up to a wage base limit that the Social Security Administration sets each year. For 2024, the wage base is $168,600, meaning you stop withholding Social Security tax once an employee's year-to-date wages reach that amount. Medicare tax is 1.45% of all gross wages with no upper limit.

To compute: multiply the gross wage by 0.062 for Social Security, and by 0.0145 for Medicare. If the employee has already earned more than the Social Security wage base earlier in the year, withhold Social Security only on the wages that fall below the cap. For example, if an employee earned $165,000 year-to-date and earns $5,000 in the current pay period, withhold Social Security tax on only $3,600 of that $5,000 (the amount that brings them to $168,600).

High-income employees also owe an additional 0.9% Medicare tax on wages over $200,000 (single) or $250,000 (married filing jointly). You withhold this as an employee tax, separate from the regular 1.45% Medicare tax, and it has no employer match.

Computing Employer Taxes: Matching and Unemployment

The employer pays a matching Social Security tax of 6.2% and a matching Medicare tax of 1.45% on every employee's gross wages, using the same wage base limits as the employee withholding. These are employer costs, not deducted from the employee's pay. You compute them the same way: multiply gross wages by the rate, and stop Social Security withholding once the employee hits the annual wage base.

Federal unemployment tax (FUTA) is 6% of the first $7,000 of each employee's annual wages. Most employers receive a credit of up to 5.4% if they pay state unemployment tax on time, which brings the effective FUTA rate down to 0.6%. To compute: multiply the first $7,000 of each employee's annual wages by 0.006 (or 0.06 if you have not paid state unemployment tax). Once an employee's year-to-date wages exceed $7,000, you stop computing FUTA for that employee for the rest of the year.

State unemployment tax (SUTA) rates and wage bases vary by state. Most states use a wage base of $7,000 to $15,000 per employee per year, and rates range from about 0.5% to 5.4% depending on the employer's industry and claims history. You must contact your state's labor or revenue department to find your rate and wage base.

State Income Tax Withholding

State income tax withholding varies widely because not all states have income tax, and those that do use different rates, brackets, and forms. Nine states have no income tax: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming, and New Hampshire (which taxes only dividends and interest). If your employee works in one of these states, you withhold no state income tax.

For states with income tax, most require an employee to file a state W-4 or equivalent form. Some states use federal withholding tables as a starting point; others publish their own. A few states allow employees to claim no withholding at all. You must check your state's tax agency website for the current withholding form, tables, and instructions. State withholding rules change less often than federal rules, but they do change, so verify annually.

Some employees work in a state different from where they live. Generally, you withhold based on where the work is performed, not where the employee lives. If an employee works in multiple states, you may need to split withholding between them. This is rare in most industries but common for remote workers and traveling employees.

Putting It Together: A Worked Example

Suppose an employee in California earns $3,000 gross in a biweekly pay period. They filed a W-4 claiming two withholding allowances and no extra withholding. Here's what you compute:

  • Federal income tax: Look up the biweekly withholding table for $3,000 gross and two allowances. The IRS table shows $256.
  • Social Security tax (employee): $3,000 × 0.062 = $186 (assuming year-to-date wages have not hit the cap).
  • Medicare tax (employee): $3,000 × 0.0145 = $43.50.
  • California state income tax: Look up California's biweekly withholding table for $3,000 and the employee's filing status. California's rate is roughly 1% to 13.3% depending on income; for this example, assume $180.
  • Total employee withholding: $256 + $186 + $43.50 + $180 = $665.50. The employee's net pay is $3,000 − $665.50 = $2,334.50.
  • Employer Social Security tax: $3,000 × 0.062 = $186.
  • Employer Medicare tax: $3,000 × 0.0145 = $43.50.
  • FUTA (if year-to-date wages are under $7,000): $3,000 × 0.006 = $18.
  • California SUTA (assume 3.4% rate and $7,000 wage base): $3,000 × 0.034 = $102.
  • Total employer cost: $3,000 (wages) + $186 + $43.50 + $18 + $102 = $3,349.50.

The employee receives $2,334.50. The employer pays $3,349.50 total. The difference between gross and net is the employee's withholding; the difference between gross and employer cost is the employer's taxes.

Common Errors and How to Avoid Them

The most frequent mistake is using outdated withholding tables or rates. Tax tables and wage bases change yearly, and using old numbers causes under- or over-withholding. Set a calendar reminder in September or October to download the new federal withholding tables and check your state's website for updates. If you use payroll software, update it before the new year begins.

Another common error is forgetting to stop withholding Social Security tax once an employee hits the annual wage base. If you withhold Social Security on wages above $168,600 (for 2024), you've over-withheld and must refund the employee. Payroll software tracks year-to-date wages and stops automatically, but if you compute manually, you must track this yourself.

Misclassifying an employee as exempt from withholding when they should be subject to it, or vice versa, also causes problems. Review each employee's W-4 when they're hired and when they update it. If an employee claims exempt status, the IRS requires them to have had no tax liability the prior year and expect none in the current year — this is rare and should be questioned if claimed by most employees.

When to Use Payroll Software or a Service

Computing payroll by hand is possible for a very small business with few employees, but it's error-prone and time-consuming. Payroll software (such as QuickBooks Payroll, Gusto, or ADP) stores employee W-4 information, tracks year-to-date wages, applies current tax tables, and computes all withholding and employer taxes automatically. It also generates pay stubs, tax reports, and deposit reminders.

A payroll service handles the entire process for you: you provide hours or salary, and they compute taxes, print checks or process direct deposit, file tax forms, and remit payments to the IRS and state. The cost is usually $20 to $50 per employee per month, but it eliminates the risk of errors and the time spent learning tax rules.

Even if you use software or a service, understanding how payroll taxes are computed helps you review the results, catch errors, and answer employee questions about their pay stubs.

Frequently Asked Questions

What happens if I withhold the wrong amount of federal income tax?

If you under-withhold, the employee owes the difference when they file their tax return and may owe penalties. If you over-withhold, they receive a refund. Either way, the error is corrected at tax time. To avoid it, use the current year's IRS withholding tables and ask employees to update their W-4 if their situation changes.

Do I have to withhold payroll taxes if an employee is paid in cash?

Yes. Withholding requirements apply to all wages, regardless of how they're paid. Paying in cash does not exempt you from withholding or from reporting the wages to the IRS. Failure to withhold and remit taxes can result in penalties and back taxes owed by the employer.

What's the difference between gross pay and taxable wages?

Gross pay is the total amount earned before any deductions. Taxable wages for federal income tax withholding are usually the same as gross pay, but certain pre-tax deductions (like health insurance premiums) reduce taxable wages. Social Security and Medicare taxes are computed on gross pay before pre-tax deductions. Check your payroll software or a tax professional if you're unsure which amount to use.

Can an employee claim exempt from federal income tax withholding?

Yes, but only if they meet strict IRS criteria: they had no tax liability in the prior year and expect none in the current year. This is rare. If an employee claims exempt, you do not withhold federal income tax, but you still withhold Social Security and Medicare taxes. The IRS can penalize employees who claim exempt incorrectly.

How often do I need to remit payroll taxes to the IRS?

Deposit frequency depends on how much payroll tax you owe. Most employers deposit federal payroll taxes monthly or semiweekly. The IRS sends a notice (Form 941-S or a letter) telling you your deposit schedule. State unemployment taxes are usually deposited quarterly. Check your state's labor department for the exact schedule.