What Are Payroll Taxes and How Do They Work?

When people ask, “What is payroll tax?” they’re usually trying to understand what’s being taken out of their paycheck and where that money goes. In simple terms, payroll tax is an umbrella term for the federal, state, and local taxes that employers withhold from employee wages and send to the government. It also includes certain employer taxes that business owners match or pay directly out of pocket.

On paper, the process sounds straightforward: calculate the tax, withhold the right amount, send it to the government, file the required forms, and distribute year-end tax forms to employees. In reality, payroll taxes can be challenging to manage because of the different tax types, rules, deadlines, and compliance requirements involved.

Every business with at least one employee is subject to payroll taxes. There’s no opting out, and the penalties for getting it wrong are steep, especially when mistakes involve missed deposits, incorrect withholding, or late filings.

Take the stress out of payroll taxes

Calculating payroll taxes is complicated, not to mention time-consuming and anxiety-inducing. A full-service payroll software provider like ADP can save you time and offer invaluable peace of mind in terms of payroll tax compliance.

Why payroll taxes matter

Payroll taxes may look like a routine payroll task, but they influence several business decisions:

• Hiring costs: If you offer a new hire a $60,000 salary, that isn’t your total cost. You’re also responsible for employer-paid payroll taxes, such as Social Security, Medicare, and unemployment taxes. Those costs add a meaningful percentage on top of base pay, and they compound as your team grows.
• Cash flow: When you run payroll, you withhold taxes from employee wages, but you don’t always deposit them immediately. Depending on your tax liability, you may need to send the money to the IRS monthly or semiweekly. That means you need to keep those funds available for tax payments instead of treating them as usable business cash.
• Risk exposure: Payroll tax compliance depends on many moving parts working together, from employee data and tax registrations to deposit schedules and filed forms. When one piece is off, the problem can carry into the next step. In my experience, the real risk is not just the penalty. It’s the time spent tracing the error, correcting records, responding to notices, and preventing the same issue from happening again.

To learn more about your employment tax responsibilities, read IRS Publication 15, or the Employer’s Tax Guide. You can also consult an accountant to confirm which federal, state, and local payroll tax obligations apply to your business.

Types of payroll taxes

Payroll taxes are easier to understand when you separate them by who pays them. Some are withheld from employee paychecks, some are paid directly by the employer, and some are shared between both.

The main federal payroll taxes are federal income tax withholding, FICA taxes, and FUTA taxes. Depending on where your business operates, you may also need to handle state income taxes, state unemployment taxes, and local taxes.

Federal income tax

As the employer, you don’t pay federal income taxes for your employees. However, you are legally responsible for withholding the correct amount from each paycheck and sending it to the IRS on the required schedule.

You don’t decide how much federal income tax an employee owes for the calendar year. Withholding is calculated using IRS withholding tables and the information each employee provides on Form W-4, such as filing status, dependents, and any additional withholding they request.

Tip: If the details on the form are outdated or entered incorrectly into your payroll system, paycheck withholding may be too high or too low. I recommend asking employees to submit a new W-4 when they get married, have a child, take a second job, or want extra withholding.

FICA taxes: Social Security & Medicare

Federal Insurance Contributions Act (FICA) taxes fund the Social Security and Medicare programs, and are shared by employees and employers. Employers withhold the employee’s share from each paycheck, remit it to the IRS, and pay an equal employer share.

The total FICA tax rate is 15.3%, split evenly, with each side paying 7.65%. That breaks down into:

• 6.2% for Social Security
• 1.45% for Medicare

For example, if an employee earns $1,000 in taxable wages, the employee’s FICA withholding is $76.50, and the employer owes $76.50, provided the employee has not passed the Social Security wage base.

Social Security taxes

Social Security tax applies only up to an annual wage base. For 2026, the Social Security wage base is $184,500.

Once an employee’s wages exceed that amount, you stop withholding the 6.2% Social Security tax for the rest of the calendar year. You also stop paying your 6.2% Social Security share on wages above that limit.

Additional Medicare taxes

Unlike Social Security tax, Medicare tax does not have a wage cap. The standard 1.45% employee tax and 1.45% employer tax apply to all covered wages, regardless of how much the employee earns.

However, Employees may also owe an Additional Medicare Tax of 0.9% on wages above certain income thresholds:

• $200,000 for single filers
• $250,000 for married filing jointly
• $125,000 for married filing separately

You must begin withholding this once an employee’s wages cross $200,000 in a calendar year, regardless of their actual filing status. There is no employer match for this tax.

FUTA taxes

FUTA stands for the Federal Unemployment Tax Act. This tax helps fund unemployment programs at the federal level, and it is paid only by employers. It is not withheld from employee paychecks.

The FUTA tax rate is 6% on the first $7,000 of each employee’s wages per year. If you pay state unemployment taxes on time and in full, you may be eligible for a credit of up to 5.4%. That can bring the effective FUTA rate down to 0.6%.

FUTA credit reductions

Employers in credit reduction states may owe more, especially if your state has borrowed from the federal government to cover unemployment benefits and hasn’t repaid on time. The IRS can reduce that 5.4% credit, increasing the employer’s federal unemployment tax cost.

For example, in the tax year 2025, California employers faced a 1.2% FUTA credit reduction because of an outstanding federal loan balance. That raised the effective FUTA rate from 0.6% to 1.8%. While the percentage may sound minor, it adds up quickly on a larger payroll.

Tip: Check the IRS or state website annually for your state’s credit reduction status before finalizing year-end tax figures.

State income taxes

Washington, D.C., and 43 states require employers to withhold state income tax from employee wages. Rules, tax rates, and wage thresholds vary by state, including the registration requirements, deposit schedules, and filing forms.

This becomes more complicated when employees work in different states. Your business may be located in one state but have payroll obligations in another if an employee physically works there.

Tip: Before running payroll for an employee in a new state, confirm whether you need to register for state withholding, unemployment insurance, or other employer payroll tax accounts. Don’t rely on your company’s headquarters location because payroll tax obligations usually follow where the employee performs the work.

SUTA taxes

Most employers pay state unemployment taxes, often called SUTA or SUI taxes, which are used to fund state unemployment insurance programs. These taxes are usually employer-paid, although Alaska, New Jersey, and Pennsylvania also require employee unemployment insurance contributions.

Unlike FUTA, SUTA rates and wage bases vary by state. New employers typically start with a standard new-employer rate until they have enough unemployment claims history for an experience-based rate. For example, the 2026 new employer UI rates are 4.1% in New York and 2.7% in Texas.

Your assigned rate may depend on your industry, payroll size, and claims history, so verify it with your state agency before running payroll in a new state.

Local payroll taxes

Local payroll taxes are set by cities, counties, or other local governments. Depending on the rule, they may be withheld from employee wages, paid directly by the employer, or both.

For example, Pennsylvania employers may need to withhold local Earned Income Tax and Local Services Tax, while those in Ohio may need to deduct school district income tax. In Maryland, local taxes are included in state withholding rates for counties and Baltimore City. Oregon also has transit-related payroll taxes that can apply based on where work is performed.

Local taxes are easy to overlook because they are not universal. A tax code locator, payroll software, an accountant, or a tax advisor can help you identify local obligations, especially if your business hires across multiple jurisdictions.

More payroll tax coverage

How payroll taxes work

Payroll taxes follow a repeatable cycle. You collect tax information, calculate wages and withholding, add employer tax amounts, deposit the money, file tax forms, and keep records.

The details vary depending on business size, location, payroll frequency, and tax liability, but most employers follow the same general process.

1. Request an Employer Identification Number (EIN)

Before you can hire employees and start depositing payroll taxes, you need an Employer Identification Number. Each business has a completely unique number for easy tax identification.

You can apply for an EIN directly through the IRS’s website. Applying for and receiving an EIN is completely free, and the online process shouldn’t take more than a few minutes.

2. Get a state EIN if required

If you pay any state-specific taxes, you’ll need to request a unique state EIN that differs from your federal EIN. Check your state’s tax agency website for the application process.

3. Collect employee tax forms

To determine how much to withhold from your employees’ paychecks, you must collect Form W-4 from every team member. It also contains the employee’s Social Security Number and home address, which are essential details you’ll need to correctly process payroll and taxes.

Contractors are not required to submit Form W-4 when they first start working with your company. Instead, they fill out IRS Form 1099, which lists the contractor’s income.

You do not need to withhold, deduct, or remit any payroll taxes on behalf of your contractors. However, you do need to distribute Form 1099 to your contractors at the end of the year so they can file taxes accordingly.

Also see: Best Contractor Payroll Services

4. Calculate taxable wages

Start with gross pay, which is the employee’s total compensation before taxes and deductions. For hourly employees, this may include regular hours, overtime, paid time off, bonuses, tips, and /or commissions. For salaried employees, it usually starts with the salary amount for the pay period, plus any taxable extras.

From there, apply any pre-tax deductions that reduce taxable wages. These may include certain health plan deductions, health savings account contributions, or retirement plan contributions, depending on the plan and tax rules.

Before payroll runs, confirm how each earning and deduction is taxed. Bonuses, commissions, fringe benefits, reimbursements, and pre-tax deductions can affect taxable wages differently.

5. Compute employee withholding and employer payroll taxes

Once taxable wages are determined, calculate the taxes to withhold from employee paychecks, such as federal income tax, the employee share of Social Security and Medicare, state income tax, local taxes, and Additional Medicare Tax if applicable.

Federal income tax withholding is more variable. It depends on the employee’s W-4 and IRS withholding tables.

You also need to compute the payroll taxes that employers should cover. This may include the employer share of Social Security and Medicare, FUTA, SUTA, and any employer-paid state or local payroll taxes.

Tip: Pay extra attention to employees approaching the Social Security wage base, employees with bonuses or commissions, and employees who updated their W-4 midyear. These are common points where errors show up.

6. Deposit payroll taxes on the correct schedule

After payroll is calculated, you must deposit both employee and employer taxes on the correct schedule. Start by determining the deadline for applicable taxes.

Federal deposit schedules are generally monthly or semiweekly, depending on the employer’s tax liability. State and local deposit schedules may be different, so verify the timelines from state and local government websites.

Payments for federal payroll taxes are generally made through the Electronic Federal Tax Payment System (EFTPS). Don’t forget to enroll before your first deposit is due. If the system is unavailable on your deadline, call the IRS at 1-800-555-3453 to make a payment by phone.

Treat withheld payroll taxes as money already owed to the government, not as available operating cash for your business. Calendar deposit dates and keep payment confirmations with your payroll records.

7. Keep payroll tax forms & keep records

Payroll tax deposits are only one part of compliance. You’ll need to file forms that report wages, taxes withheld, employer tax amounts, and unemployment taxes.

Common federal payroll tax forms include:

• Form 941: Employer’s Quarterly Federal Tax Return
• Form 940: Employer’s Annual Federal Unemployment Tax Return
• Form W-2: Wage and Tax Statement for employees
• Form W-3: Transmittal of Wage and Tax Statements
• Form 1099-NEC: Nonemployee compensation reporting for eligible contractors

Some employers may use other forms, such as Form 944 (Employer’s Annual Federal Tax Return) or Form 945 (Annual Return of Withheld Federal Income Tax), depending on their situation.

Keep payroll records that show how wages were calculated, what taxes were withheld, when deposits were made, and what forms were filed. Key records include W-4s, state withholding forms, payroll registers, time records, tax deposit confirmations, quarterly and annual filings, W-2s, 1099s, and payroll adjustment records.

Want to automate payroll tax calculations, payments, and filings? Read our guide to the best payroll software to see our top picks.

Common payroll tax mistakes and how to avoid them

Most payroll tax mistakes come from outdated settings, missed handoffs, or skipped reviews. Use this checklist to catch common issues before they turn into penalties or year-end cleanup.

These mistakes usually become expensive when they repeat across multiple pay periods, so the goal is not just to correct errors but to build review points into the payroll process before deposits and filings are due.

Frequently asked questions (FAQs)

Are payroll taxes the same as employment taxes?

They’re closely related and are often used interchangeably. “Employment taxes” is the term the IRS commonly uses for employer tax responsibilities, while “payroll taxes” is the more common business term for the taxes calculated, withheld, paid, and reported through payroll.

What happens if an employer pays payroll taxes late?

Late payroll tax deposits can lead to penalties and interest. The cost depends on how late the deposit is and how much tax is owed. Because withheld payroll taxes are considered funds held for the government, repeated or serious failures can create bigger compliance issues.

Are employer payroll taxes deductible?

The employer-paid portion of payroll taxes is generally treated as a business expense. This may reduce taxable business income, but it does not reduce the payroll tax rate itself. To confirm deduction rules, consult with an accountant or tax advisor.

What is the difference between payroll tax and self-employment tax?

Payroll tax applies to employee wages and is split between the employee and employer for FICA taxes. Self-employment tax applies to people who work for themselves and generally pay both the employee and employer portions of Social Security and Medicare.

Do payroll taxes apply to bonuses?

Yes. Bonuses are generally treated as supplemental wages and may be subject to federal income tax withholding, FICA, and applicable state or local taxes. Bonus withholding may follow different IRS methods than regular wages, so employers should confirm their payroll setup before issuing bonus payments.

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