A Complete Guide to Federal Payroll Taxes: Insights on Rates and Compliance

Distinguishing Payroll Taxes from Income Taxes

Payroll and Income taxes also follow separate rules for calculation, withholding, and filing. Employer payroll taxes, or taxes from employee wages, primarily fund federal social insurance programs like Social Security and Medicare. 

While payroll taxes are used to support Social Security, Medicare and unemployment taxes, go toward the general federal budget. These taxes are shared by both the employee and the employer and are calculated as a fixed percentage of the employee’s wages or taxable income. Payroll tax obligations are consistent and predictable, making proper payroll tax deposit scheduling critical for employers to avoid unpaid taxes.

Income taxes are withheld from an employee’s paycheck based on the information provided by employees on the IRS Form W-4 including deductions and filing status. From time to time, the Federal government does change the federal tax rates.

A clear understanding of the differences between payroll taxes helps ensure accurate tax withholding, improves compliance with Internal Revenue Service (IRS) regulations, accurate tax reporting and supports better financial planning for businesses, workers and payroll service providers.

Key Components of Federal Payroll Taxes

Social Security Taxes

Employer payroll taxes include Federal Insurance Contributions Act (FICA Taxes), or Social Security and Medicare Taxes. These taxes are jointly paid by employees and employers and are deducted from each paycheck, or taxable wages, for business days worked. FICA is a U.S. federal payroll tax deducted from each paycheck. Employers pay their share of the taxes and withhold an equal amount from their employees’ wages, 6.2% of employees' gross wages are contributed to Social Security tax (Old Age, Survivors, and Disability Insurance [OASDI]). The Social Security tax has an annual wage base limit of $176,100, and the maximum Social Security Tax for 2025 is $10,918.20. 

Medicare Taxes

The Medicare (Hospital Insurance) Tax has no annual gross salary limit. The Medicare Tax Rate, 1.45%, applies to all taxable wages. A 0.9% additional Medicare Tax is assessed against all gross wages higher than $200,000 (for $250,000 for married couples filing jointly). Employers do not contribute a share of the additional Medicare tax. 

The FICA Tax Rate, combining Social Security’s rate of 6.2%, and Medicare’s 1.45%, is 7.65% (or 8.55% for employees earning $200,000 or more). Employers match the Social Security and Medicare taxes for a total of 15.3% of taxable income. In some scenarios, employers must withhold the 0.9% additional Medicare Tax but are not required to match it—so it would no be considered unpaid taxes..

Federal Unemployment Tax Act (FUTA)

The Federal Unemployment Tax Act (FUTA), requires employers to pay unemployment taxes to support state unemployment insurance, as regulated by the Internal Revenue Service (IRS). Employers file IRS form 940 on an annual deposit schedule when paying the payroll unemployment taxes. The federal unemployment tax funds the administration of unemployment insurance (UI) and Job Service programs in all states. Hourly ages and salary compensation must be accurately tracked to calculate correct payroll tax deposits.

Calculating Federal Payroll Taxes

Understanding Rates and Limits

Employers must deposit and report federal employment taxes based on an employee’s taxable income or tax liability. Employers and employees pay some of these taxes, while others are paid only by the employer. Examples of federal tax deposits include federal income tax, FICA, and federal unemployment tax in the employer payroll taxes for the payroll tax liability.

To calculate federal income taxes withholding from wages or the payroll tax rates, the IRS recommends that employers’ use the employees’ IRS Form W-4, Employee’s Withholding Certificate, the appropriate method, and the withholding table described in Publication 15-T, Federal Income Tax Withholding Methods. Employees who earn a salary or receive hourly wages can choose a standard deduction or itemized deductions when they file their annual tax forms when filling out the employee’s W4 form.

The Tax Withholding Estimator tool on the W4 form can help employees estimate the federal income tax to be withheld from their paychecks when filling out withholding forms. Income tax is also determined by an employee’s tax rate. Employees receive a W2 form at year end to file their annual federal and state income tax returns. The tax filing status is determined if a person is filing as an individual or marital status, a couple filing jointly. Employers are responsible for withholding the correct amount based on IRS tables and employee-provided information, including:

• Filing status single, married filing jointly.
• Standard deductions of itemized deductions.
• Any additional taxes employees want withheld voluntarily.

Filing Requirements for Employers

Detailed Guide to Form W-4

The IRS W-4 form, or the "Employee's Withholding Certificate," is filled out by employees and submitted to their employers. Employers utilize the information on a W-4 to determine the withholdings from an employee's gross pay,  biweekly for exempt workers, i.e., salaried employees, and hourly for non-exempt workers. New employees, salaried or hourly, file a W4, a direct deposit authorization form, and a few other forms, as part of the payroll obligations. Salaried workers may earn a salary on legal holidays, but it’s not always the case for hourly workers.

For tax payments, employees can no longer change the number of allowances, just dependents, after a change in the W-4 form in 2020. Employees who earn $200,000 or less ($400,000 or less if filing jointly) can list the number of their kids and dependents and multiply them by the credit amount, $2,000 for each child younger than 17 and $500 for other dependents, which impacts federal tax withholding. In Step 4(c) of the form, employees can request  additional withholdings per paycheck, or additional taxes. In Line 4(a), employees can detail income received without withholding taxes, such as retirement or interest income. Line 4(b) is for itemizing deductions, and the IRS includes a Deductions Worksheet on page three to aid in that process.

Filing Form 940

Business owners use Form 940 to report the annual FUTA tax, or federal unemployment tax. Together with state unemployment tax systems, the FUTA tax provides funds for unemployment benefits. The FUTA tax applies to the first $7,000 of each employee’s salary during a calendar year after subtracting payments exempt from  federal unemployment tax.

Form 940 can be filed electronically. Companies must file the form if they paid wages of $1,500 or greater in any calendar quarter during 2023 or 2024 or had one or more employees at least part of day in 20 or more weeks in 20 or more weeks in 2023 or 2024.

The IRS instructs companies to count all full-time, part-time, and temporary employees for Form 940. Partnerships do not have to count their partners.

Submission of Form 941

The form is a company’s federal tax return paid on a quarterly schedule.

The form’s purpose:

• Report income taxes, Social Security tax, and Medicare tax withheld from employees' paychecks.
• Pay the employer's portion of Social Security or Medicare tax.

The IRS explains that if a company pays wages subject to federal income tax withholding or Social Security and Medicare taxes, it must file Form 941 quarterly to report the following amounts:

• Wages paid.
• Tips that employees reported to their employers.
• Federal income tax withheld.
• The amount the business owner and the employee paid Social Security and Medicare taxes.
• Additional Medicare Tax withheld from employees.
• The current quarter's adjustments to Social Security and Medicare taxes for fractions of cents, sick pay, tips, and group-term life insurance.
• Qualified small business payroll tax credit for increasing research activities.

Backup withholding or income tax withholding on non-payroll payments such as pensions, annuities and gambling winnings, are reported on Form 945.

Compliance with Federal Payroll Tax Regulations

Importance of Compliance

Maintaining payroll compliance and paying federal taxes is crucial to avoid IRS penalties, interest charges, and potential audits. In 2023, the U.S. Department of Labor recovered over $274 million in back wages for nearly 152,000 workers due to payroll violations.

To stay up-to-date with state and federal payroll law changes, companies should subscribe to IRS and state tax agency newsletters, and review Department of Labor updates regularly. Companies should also create a compliance calendar to track payroll and tax deadlines. Quarterly audits ensure employee wages are accurate and errors are caught before tax deadlines.

Common Mistakes to Avoid

Misclassifying employees can lead to violating labor rules and regulations, so companies need to know them in depth and adhere to them. Payroll rules vary significantly from state to state, and missing quarterly tax deposit deadlines can trigger IRS penalties. 

The next set of requirements is accurately tracking workers' regular hours and overtime work (time-and-half for over 40 hours in a week), and also failing to factor standard deductions and additional taxes.

Business owners can track these hours by purchasing time-tracking software to complete these chores quickly and reduce or eliminate manual errors. Companies should also file pay stubs, payroll registers, W-2s, W-4s, and I-9 forms for  maintaining proper payroll records. The Fair Labor Standards Act (FLSA) requires that payroll records should be stored for at least three years. The U.S. Department of Labor administers the federal law and determines minimum wage, overtime pay, recordkeeping, and youth employment standards for most U.S. full-time and part-time workers. 

Potential Penalties for Non-Compliance

IRS penalties for payroll tax errors can climb to 15% of the unpaid wages. Violating FLSA laws may compel businesses to pay large fines for unpaid overtime. Employee misclassification fines can lead to audits and cost businesses thousands of dollars per worker. 

Best Practices for Managing Federal Payroll Taxes

Categorization of Employees vs. Contractors

Business owners must determine whether employees are employees or independent contractors. Unlike full-time employees, business owners do not have to withhold social security and medicare or pay taxes on payments to independent contractors.

Independent contractor status depends on a few factors, such as does the company control or has the right to control the workers' daily duties and how workers perform their responsibilities. Financial issues include how the worker is being paid and reimbursed for expenses or if they receive employee benefits like a pension and vacation pay. Companies must also document the factors determining the worker's status.

Adhering to Federal and State Regulations

Federal income tax is calculated based on the employee’s Form W-4 and IRS tax tables. First, employers should check the employee’s filing status (single, married, head of household).

Then, use the employee's Form W-4, Employee’s Withholding Certificate, the appropriate method and withholding table in the IRS’ Publication 15-T, Federal Income Tax Withholding Methods.

• Deduct pre-tax deductions such as health benefits and retirement funds.
• Use the tax bracket to determine the withholding amount.

State income tax varies by state, and eight states don’t have income tax, such as Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming. State unemployment insurance rates vary based on state and employer history. Some cities and municipalities levy additional payroll taxes.

Utilizing Resources for Payroll Tax Management

Payroll software can provide several reports on a company-wide or individual level about total salaries, deductions, or taxes paid in a specific quarter or tax year.

Payroll software service providers can also integrate tax credits and wage thresholds to help with compliance and cost management. Payroll software and services should automate the preparation, filing, and paying of taxes based on where a company's workers live. Payroll software should offer several methods to pay employees: checks, direct deposit, or prepaid debit cards.

If a company has employees and contractors who are paid on different schedules, a payroll solution with unlimited payroll runs for flexibility is necessary.

Payroll software and services offer an online portal for HR staff, payroll administrators, and employees to view and correct payroll-related data.

Professional Services and Advisors

Payroll specialists, or professional services and advisors can provide advanced knowledge about HR management, compliance, risk management, and payroll services. These consultants can assist businesses in establishing strong HR policies, managing employee relations, and complying with labor laws.

Payroll Tax Basics: Questions and Answers