Payroll Taxes: The Nanny State Working for You

Q: Tax Playa, what type of payroll taxes do I need to pay for my employees?
Terrence, Arlington VA

A: There are three basic payroll taxes that employers must remit on behalf of employees: Social Security, Medicare (collectively known as FICA), and unemployment insurance (FUTA and state-level equivalent).  All of them work very differently, so it's important to keep all of them straight...

or more information on this, please consult IRS Publication 15, Employer's Tax Guide.

Most people are aware of the bulk of federal taxes paid--personal and corporate income taxes.  Together, these account for about 60% of all federal taxes paid.

Employers have a "payroll tax" of sorts that they pay all the time--withholding for federal income tax payments.  While this is a kind of payroll tax, it's more like an income tax using a payroll device--not really what I'm getting at here, but worth mentioning to be comprehensive.

The second-biggest source of federal tax payments is payroll taxes.  These also happen to represent the largest chunk of federal taxes paid by a majority of households.  They are largely a relic of New Deal and Great Society thinking, and are the product of a time when large employers, wages, unions, and government benefits were the norm.  If these taxes weren't so destructive to the economy and to poorer workers, they'd be a quaint museum display.

Unfortunately, they are very real.  Let's get into the components of each and how they work, in order from largest to smallest:

1. Social Security.  The payroll tax on Social Security for 2008 is 12.4% of wages and self-employment income up to a cap of $102,000.  The self-employed pay the full 12.4% tax up to this level (deducting half of it against ordinary income).  Employers and employees each pay 6.2%, with the former getting a tax deduction against business income for their half.

If an employee works multiple jobs during the year, the employer is required to withhold Social Security taxes for the first $102,000 of every job.  High-income employees may find themselves paying more Social Security tax than they need to.  They can take a tax credit for this on their income tax return.

The Social Security tax is directed to two "trust funds"--the Old-Age and Survivors Insurance (OASI) fund (10.8 percentage points), and the Disability Insurance (DI) fund (1.6 percentage points).  These "trust funds" are merely accounting fictions the federal government has created. 

As a point of fact, the DI trust fund will run out of cash to pay benefits within a decade, and the OASI fund less than a decade after that.  At that point, taxes will be raised or benefits will be reduced (or debt will be incurred, really a delay of either of those).

2. Medicare.  The payroll tax on Medicare is all wages and self-employment income, with no cap.  The rate is 2.9%.  The self-employed pay the full 2.9% tax, deducting half of it against ordinary income.  Employers and employees each pay 1.45%, with the former getting a tax deduction against business income for their half.

The Medicare payroll tax is directed to the Hospital Insurance (HI) trust fund, which funds Medicare Part A (I won't bore you with financing of the Medicare program, which is outside the scope of this article).  Like its Social Security cousin, the HI trust fund will run out of cash in less than a decade.  Historically, Congress has reacted to this not by cutting benefits or raising taxes directly, but by shifting responsibilities from Medicare Part A (financed entirely with this payroll tax) to Medicare Part B (financed about 75% by taxpayers and about 25% by beneficiaries).

FICA

Taken together, Social Security and Medicare payroll taxes form one large payroll tax obligation known as FICA: the Federal Insurance Contribution Act.  For the true tax geeks, the self-employed technically don't pay FICA, but SECA: the Self-Employed Contribution Act.

FICA taxes must be paid and filed quarterly by employers.  Employers file either Form 941 or 944 (if eligible to do so annually) to make these payments.

Household Employees

If you retained the services of an unincorporated household employee (maid, nanny, gardener, cook, etc.), he is considered your common-law employee.  We have already discussed these employees in more detail here, but suffice it to say that FICA taxes must be paid on their behalf.

3. Unemployment Taxes.  Most employers who maintain a fairly stable workforce or pay more than nominal wages are subject to the Federal Unemployment Tax Act, or FUTA (the self-employed are exempt).  The FUTA tax is 6.2% of wages per employee per year up to $7000 of wages.  It is entirely-paid by the employer.  Thus, the maximum FUTA tax per employee is $434.

It gets even better.  FUTA is simply a supplement to the main unemployment insurance system, the one run by the states.  If you are fully-paid into your state unemployment insurance system, you can take a credit off your FUTA tax for up to 5.4% of $7000 in wages, or $378.

Thus, an employer who has an employee earning at least $7000 and paying state unemployment insurance will usually only face an effective FUTA liability of $56.

The employer reports FUTA tax owed, as well as summarizes FICA tax paid, on an annual Form 940 that is filed with the IRS.

Family Employees

There are several family employment situations which do not require the payment of some or all of these payroll taxes:

1. A child under the age of 18 who works in a trade or business for his unincorporated parent's business is not liable for Social Security, Medicare, or unemployment tax.
2. A child under the age of 21 who works for their parents in a domestic capacity is not liable for Social Security, Medicare, or unemployment tax.
3. One spouse hiring another does not have to pay unemployment tax.
4. Children employing parents to care for their own children do not have to pay Social Security, Medicare, or unemployment taxes if the care is for less than four consecutive weeks (in most cases).

Comments

[Craig]

I have an employee living and working full-time overseas and paying no state taxes. What is the FUTA tax due in this situation? The full 6.2% rate?

[Anthony Palmer, M.D.]

I currently have an HSA and am still working part-time. I will turn 65 on November 2008 and will probably have no choice but to enroll on Medicare (yuk!). How will turning 65 and being on Medicare affect my 2008 HSA contribution? And can I have an HSA on Medicare?
Thanks.