“In this world, nothing is certain except death and taxes.”

These words, uttered by Benjamin Franklin more than 200 years ago, still resonate today. However, unsurprisingly, the American tax system has only become more complex since then. 

Navigating these complexities — particularly when it comes to payroll management — is imperative for small business owners. This process begins with understanding and properly managing payroll and income taxes. While these terms are often used interchangeably, they have distinct purposes and impact employers and employees in different ways. 

In this article, we’ll explore the key differences between payroll and income taxes, outlining what each covers, who is responsible for paying them, and how they’re calculated. Whether you’re issuing paychecks or receiving them, understanding these taxes is essential for maintaining financial accuracy and ensuring compliance with government regulations.

What's the Difference Between Payroll Taxes and Income Taxes?

Payroll taxes include contributions to Social Security, Medicare, and unemployment compensation. Employees and employers typically share the responsibility for paying these taxes.

Social Security and Medicare taxes, often identified as Federal Insurance Contributions Act (FICA) taxes, are among the most common withholdings. Employees are required to pay 6.2% of their salaries up to a specific base limit ($168,600 in 2024) and 1.45% for Medicare. For individuals earning more than $200,000, an additional 0.9% Medicare tax is imposed.

Both employers and employees contribute equally to these taxes. For example, if an employee earns $1,923.08 in a pay period, here’s how the withholdings are determined:

• Social Security contribution: $1,923.08 x 6.2% = $119.26.
• Medicare contribution: $1,923.08 x 1.45% = $27.88.
• The total FICA contribution is $147.14, which is the amount withheld from the employee’s paycheck. The employer must also match this amount, bringing the total contribution for this pay period to $294.28.

Most employers are required to pay both federal (FUTA) and state (SUTA) unemployment taxes, though rates vary by state. The current FUTA rate is 6% on the first $7,000 of each employee's annual wages. SUTA may apply to different income levels depending on state regulations.

Income Taxes 

Income tax is a levy imposed by the federal government (and many states) on individuals, businesses, and various entities based on their income or profits. Income tax is solely the responsibility of the employee. Employers are responsible for withholding the correct amount from employees' paychecks and submitting it to the appropriate tax authorities, but they don’t pay this tax themselves.

Income tax applies to wages and salaries as well as a wide range of income sources, including interest, dividends, rents, royalties, lottery and gambling winnings, unemployment benefits, and profits from businesses owned by individuals.

As of 2024, nine states — Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming — do not charge a formal income tax. New Hampshire exclusively taxes dividend and interest income while Washington only taxes capital gains income. 

Calculating federal income tax can be complex, involving withholding tables, standard deductions, wage brackets, and exemptions. For example, if an individual has a taxable income of $58,000 after deductions, his or her income tax liability will be determined based on the applicable tax brackets for that year. 

Progressive Vs. Flat Rates Vs. Marginal

Income tax is levied in several forms, including progressive, flat, and marginal tax rates. 

A progressive tax rate increases as an individual’s income increases. The federal income tax in the U.S. is progressive, ranging from 10%-37%. Progressive taxes are popular because they shift the burden of paying taxes to those who are likely most able to pay. This model allows for additional relief for low-income taxpayers. On the federal level, this is demonstrated through the Earned Income Tax Credit. 

With a flat tax, everyone pays the same amount, regardless of income. A vehicle registration fee is a perfect example of a flat tax — a 2020 Buick Encore will carry the same fee (by state), regardless of how much an owner earns. Flat taxes are often preferred because of their simplicity; however, this approach tends to place a larger burden on those with lower incomes. 

The following 13 states employ flat income taxes: Arizona (2.5%), Colorado (4.4%), Georgia (5.49%), Idaho (5.8%), Illinois (4.95%), Indiana (3.05%), Kentucky (4%), Michigan (4.25%), Mississippi (4.7% on all income after the first $10,000), New Hampshire (3% on interest and dividend tax), North Carolina (4.5%), Pennsylvania (3.07%), and Utah (4.65%). 

A marginal tax rate is the tax rate paid on the highest dollar of taxable income. Thus, as income grows, the highest dollar earned will fall into a higher tax bracket. This means a taxpayer’s marginal tax rate will likely be higher than his or her effective tax rate, which is the average rate paid on all your income. This method of taxation is known as progressive taxation. It aims to tax individuals based on their earnings so that low-income earners are taxed at a lower rate than higher-income earners.

How to Calculate Payroll and Income Taxes

Let’s examine how an employee in Michigan who earned $100,000 in 2023 would calculate his or her tax liability. 

Before calculating these amounts, we must establish the tax rates. Based on the IRS’s 2023 tax brackets, the federal income tax would be:

• 10% on income up to $11,000;
• 12% on income from $11,001 to $44,725;
• 22% on income from $44,726 to $95,375; and
• 24% on income from $95,376 to $182,100.

The Social Security tax rate in 2023 was 6.2% on earnings up to $160,200 for 2023, and the Medicare tax rate was 1.45% on all earnings. For 2023, Michigan’s flat income tax rate was 4.25%.

Step-by-Step Calculation

1. Federal Income Tax Calculation

For $100,000, the tax owed can be calculated accordingly, based on the IRS’s tax brackets.

• The first $11,000 earned is taxed at 10%. ($11,000 x 0.10) = $1,100
• Earnings between $11,001 and $44,725 are taxed at 12%. ($33,724 x 0.12) = $4,047
• Earnings between $44,726 and $95,375 are taxed at 22%. (50,649 x 0.22) = $11,143
• Earnings between $95,376 and $182,100 are taxed at 24%. ($100,00-$95,376) 0.24 = $1,110

Then, add each of the tax amounts together to determine the employee’s federal income tax liability. ($1,100 + $4,047 + $11,143 + $1,110) = $17,400

2. Social Security Tax Calculation

The Social Security tax rate in 2023 is 6.2%. To determine the tax liability, multiply $100,000 by 6.2%.
($100,000 x 0.062) = $6,200.

3. Medicare Tax Calculation

The Medicare tax rate in 2023 is 1.45%. To determine the tax liability, multiply $100,000 by 1.45%.
($100,000 x 0.0145) = $1,450.

4. Michigan State Income Tax Calculation

Michigan imposes a flat tax of 4.25%. To determine the tax liability, multiply $100,000 by 4.25%. ($100,000 x 0.0425) = $4,250.

Summary of Payroll Taxes

Now, we can summarize the total tax liability:

• Federal Income Tax: $17,400
• Social Security Tax: $6,200
• Medicare Tax: $1,450
• Michigan State Income Tax: $4,250

Adding all of these together gives us the total payroll taxes for an individual earning $100,000 in Michigan. 

($17,400 + $6,200 + $1,450 + $4,250) = $29,300.

Thus, an individual earning $100,000 in Michigan carried a total payroll tax liability of $29,300 in 2023.

Recent Income Tax Changes

Tax laws change quite frequently. Over the last three years, more than 25 states cut their income tax rates. Contrarily, Massachusetts and Washington, D.C., increased their top marginal tax rates. 

Keeping track of these changes can be cumbersome. Workforce management software, such as OnTheClock, aims to reduce the risk of manual mistakes by automating time tracking and payroll functions, allowing businesses to remain compliant and on top of tax code changes without the stress. 

Here’s a look at some of the most recent income tax alterations throughout the country.

Arkansas: Arkansas reduced its top individual income tax rate from 4.7% to 4.4% for tax years starting Jan. 1, 2024. This rate applies to incomes between $24,300 and $87,000 for taxpayers earning $87,000 or less and to incomes over $8,801 for those earning more than $87,000.

Connecticut: In 2024, Connecticut reduced its individual income tax rates for the two lowest brackets from 3% to 2% and from 5% to 4.5%. Taxpayers with annual incomes of $150,000 or more (or $300,000 for married couples filing jointly) were not affected.

Georgia: Georgia moved from a graduated income tax with a top rate of 5.75% to a flat tax of 5.49% in 2024. Additionally, the state is increasing its personal exemptions to $12,000 for single taxpayers and $18,500 for married couples filing jointly, as enacted by HB 1437 in April 2022.

Indiana: HB 1001, passed in May 2023, helped lower Indiana’s individual income tax rate from 3.15% in 2023 to 3.05% in 2024. The law also repealed previous tax triggers, specifying further reductions to 3% in 2025, 2.95% in 2026, and 2.9% in 2027 and beyond.

Iowa: Starting in 2024, Iowa consolidated its four individual income tax brackets into three, reducing the top rate from 6% to 5.7%. The state is scheduled to implement a flat income tax rate of 3.9% by 2026.

Kentucky: Kentucky's flat individual income tax rate reduced from 4.5% in 2023 to 4% starting in 2024, courtesy of HB 1.

Mississippi: The state’s tax rate decreased from 5% to 4.7% on taxable income exceeding $10,000 in 2024. 

Missouri: The state’s top income tax rate was reduced from 4.95% to 4.8% in 2024. 

Montana: Montana decreased its tax brackets from seven to two in 2024 and incorporated a top tax rate of 5.9%. Taxpayers will base their state taxable income using federal taxable income brackets.

Nebraska: Nebraska lowered its top individual income tax rate from 6.64% in 2023 to 5.84% in 2024. That rate is set to gradually reduce to 3.99% by 2027.

New Hampshire: New Hampshire is continuing to phase out its interest and dividends tax. In 2024, the tax rate dropped from 4% to 3%, with full repeal set for 2025.

North Carolina: North Carolina's flat individual income tax rate reduced from 4.75% to 4.5% in 2024. The rate is expected to decline to 3.99% by 2026.

Ohio: In July 2023, Ohio reduced its number of individual income tax brackets from three to two and lowered the top rate from 3.75% to 3.5%.

South Carolina: South Carolina reduced its top individual income tax rate from 6.5% to 6.4% in 2024. Further reductions to 6% are scheduled, contingent on general fund revenue triggers. 

How Can I Simplify the Tax Process?

Per Benjamin Franklin, if you’re still breathing, that means you’re inching toward a tax deadline. 

Calculating payroll and income taxes can be a daunting task, especially when considering the different rates, deductions, and regulations at both the federal and state level. The complexities only increase as tax laws change, making it crucial for businesses and employees to stay informed and accurate. Managing this process manually opens the door to costly errors, whether it's under- or over-withholding, missing deadlines, or miscalculating contributions.

Tools, such as OnTheClock, exist to help simplify the tax process, as they integrate with payroll systems to ensure accurate tax calculations and reporting. By automating time tracking and payroll processes, businesses can reduce administrative burdens, minimize errors, and remain compliant with ever-changing tax laws. Save time, stay organized, and ensure that payroll is one less thing to worry about with OnTheClock!