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Payroll Taxes: What Are They?

CNBC.com
Monday, 29 Oct 2012 | 10:27 AM ET
Comstock | Getty Images

Anyone looking at their paycheck stub and seeing the laundry list of taxes taken out might be wondering, 'Why am I paying these and where does all that money go?'

To help clarify the concept behind payroll taxes—and to see where the money goes, CNBC explains.

What are payroll taxes?

Payroll tax is a catch-all phrase that actually refers to two similar types of taxes.

One type are the taxes that an employee must pay and that are collected or deducted from paychecks by employers.

These taxes are more specifically called either "withholding," "pay-as-you-earn" or "pay-as-you-go taxes." These taxes make up most — but not all —of the deducted items that workers see on their payroll stubs.

The second kind of payroll tax refers to the taxes that employers are required to pay for their employees. These are directly related to some of the payroll taxes that workers must pay. We'll focus on those in a bit.

What specific taxes are deducted from a paycheck?

Income taxes:

Workers must pay federal, state and local income taxes. Some cities like New York also require income taxes. Just how much is deducted is determined by the employee on his or her tax status on IRS Form W-4.

Income taxes withheld from payroll are not final taxes, but 'prepayments.' Depending on a worker's tax bracket and deductions, some of this money can be refunded from state and federal governments come tax time. In other cases, workers may owe more income tax than they've had deducted from their checks.

Social Security and Medicare:

Workers also pay what's called social insurance taxes to fund Social Security and Medicare —for which they become eligible when they retire or reach a qualifying age.

Currently, the employee's contribution for both is 4.2 percent up to an annual wage maximum of $110,100.

For an executive with an annual salary of $300,000 in the year 2012, only the first $110,100 is subject to the Social Security tax. This means that some $4,624.20 will be deducted from their paycheck. For Medicare, the deduction taken out of the exec's paycheck would be $4,350.

Like income taxes, workers can get a tax refund for the year from these tax payments. That would happen if a workers' portion of social insurance taxes exceeded the maximum because, for instance, they had multiple employers in one year.

Unemployment taxes:

There are three states, Alaska, New Jersey, and Pennsylvania, that withhold taxes from employee wages in order to fund unemployment insurance. But mostly, unemployment is paid for by the employer, as we'll see below.

What payroll taxes must employers contribute to?

Social Security and Medicare:

Employers must contribute to Social Security and Medicare. Currently, that amount is 6.2 percent of a worker's paycheck, up to $110,100. For the exec mentioned above — with a pay check of $300,000 a year — the employer will pay $6,826.20. For Medicare, the employer would match the amounted deducted of the exec described above — $4,350.

Unemployment taxes:

Employers are subject to unemployment taxes by federal and all state governments. The tax is a percentage of taxable wages with a cap. The tax rate and cap vary by state and by the employer's industry and experience rating. For 2009, the typical maximum tax per employee was under $1,000.

Employers also pay a per-employee federal tax, which funds administrative costs of implementing the unemployment system.

Worker compensation:

Worker compensation insurance provides coverage for employees injured on the job. State law usually requires that employers carry this insurance. Worker compensation insurance rates are a function of at least three variables: the type of business or industry, the type of job being performed, and the employer's history of claims.

What are other deductions on paychecks?

If the list of deductions exceeds the above-mentioned items, that's because the worker likely has other types of deductions taken out with each paycheck. Those can include 401k contributions, pensions (for those companies that still have them), and health care insurance costs.

What are the penalties if these taxes are not reported?

If an employer does not pay federal payroll taxes in a timely manner, they are subject to an automatic penalty of 2 percent to 10 percent. Similar state and local penalties apply.

A severe penalty applies where federal income tax withholding and Social Security taxes are not paid to the IRS. The penalty of up to 100 percent of the amount not paid can be assessed against the employer entity as well as any person (such as a corporate officer) having control or custody of the funds from which payment should have been made.

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