Payroll Taxes Explained
Payroll taxes fall into two buckets: taxes you withhold from your employee's pay and remit on their behalf, and taxes your business owes on top of wages as its own expense. Withheld taxes generally include federal income tax, the employee share of Social Security and Medicare, and state and local income tax where applicable; employer taxes generally include the employer share of Social Security and Medicare, federal unemployment tax, and state unemployment tax.
Understanding the split matters because the two buckets carry different risk. Withheld taxes are held in trust for someone else, and failing to remit them is treated far more seriously than being late on your own tax liability.
This guide explains the concepts, the deposit mechanic, and the return-filing cycle without listing this year's rates — those change annually, so the specific figures are marked for verification rather than baked into the page.
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This is general educational information explaining how payroll taxes work, not tax, legal, or accounting advice for your specific situation. Rates, wage bases, thresholds, deposit schedules, and deadlines change annually and vary by state and locality. Confirm current figures with the IRS and your state agency, and consult your own CPA about your business.
The short answer
Payroll taxes fall into two buckets: taxes you withhold from your employee's pay and remit on their behalf, and taxes your business owes on top of wages as its own expense. Withheld taxes generally include federal income tax, the employee share of Social Security and Medicare, and state and local income tax where applicable; employer taxes generally include the employer share of Social Security and Medicare, federal unemployment tax, and state unemployment tax.
Understanding the split matters because the two buckets carry different risk. Withheld taxes are held in trust for someone else, and failing to remit them is treated far more seriously than being late on your own tax liability.
This guide explains the concepts, the deposit mechanic, and the return-filing cycle without listing this year's rates — those change annually, so the specific figures are marked for verification rather than baked into the page.
What you need before you start
- Your federal EIN and your assigned federal deposit schedule.
- Your state withholding and state unemployment account numbers, plus your assigned state unemployment rate.
- The state and locality where each employee physically performs work.
- Each employee's Form W-4 and any state withholding certificate.
- Payroll records showing gross wages, each tax withheld, and each deposit made.
Step-by-step
- 1
Understand what you withhold from the employee
Federal income tax withholding is based on the employee's Form W-4 and their wages for the period. It isn't a flat rate — it's an estimate of the employee's eventual income tax liability, which is why the W-4 matters and why employees sometimes ask you to change it.
You also withhold the employee's share of Social Security tax and Medicare tax, collectively FICA. Social Security applies only until the employee's wages for the year reach the Social Security wage base; Medicare has no wage ceiling and has an additional amount that applies to higher earners — current IRS figure being verified: insert current Social Security and Medicare rates, the current wage base, and the additional Medicare threshold, with the date verified.
Finally, withhold state income tax where your employee's state imposes it, and local income tax where a city, county, or school district imposes one. A handful of states have no wage income tax at all, and a few localities have their own separate filings.
- 2
Understand what your business owes on top of wages
Your business matches the employee's Social Security and Medicare contributions. This is a real cost of employment, not a deduction from the employee's pay, and it's the number owners most often forget when budgeting a new hire.
You also owe federal unemployment tax, reported annually on Form 940, and state unemployment tax, reported to your state usually each quarter. Federal unemployment tax generally applies only to a limited amount of each employee's wages, and paying your state unemployment tax on time can affect what you owe federally — current IRS figure being verified: insert the current federal unemployment rate, wage base, and the credit mechanic for timely state payments.
State unemployment rates are assigned to your business individually, based partly on your claims history, so two competitors in the same state can pay different rates. current IRS figure being verified: insert your state's current unemployment wage base and note where to find your assigned rate.
Some states impose additional employer or employee payroll taxes — disability insurance, paid family leave, or local levies. Check your state's requirements rather than assuming the federal picture is complete.
- 3
Know the difference between withholding and depositing
Withholding happens when you run payroll: you calculate what comes out of the employee's gross pay and reduce their net pay accordingly. Depositing happens separately, when you actually send that money plus your employer taxes to the government.
Between those two events, the withheld money sits in your bank account while legally belonging to someone else. That gap is where businesses get into trouble, because a healthy-looking balance can include weeks of payroll taxes that aren't yours to spend.
- 4
Deposit on your assigned schedule
Federal payroll tax deposits are made electronically, and your deposit frequency is assigned based on your payroll tax liability during a lookback period — you don't choose it. Most small employers fall on one of two federal schedules, and there are additional rules that accelerate the deadline if your liability reaches a high threshold — current IRS figure being verified: insert the current lookback period, the deposit due dates for each schedule, and the accelerated-deposit threshold.
State deposit schedules are separate, often on a different cadence, and may be assigned by a different measure. Track both, because being current federally doesn't mean you're current with your state.
Deposit penalties generally escalate the longer the payment is late, and amounts you withheld from employees are treated with particular severity. current IRS figure being verified: insert the current penalty tiers if you want them stated on the page.
- 5
File the quarterly returns
Most employers report wages, federal income tax withheld, and Social Security and Medicare taxes each quarter on Form 941, which also reconciles the quarter's liability against the deposits you already made. Your state generally requires its own quarterly withholding return and a quarterly unemployment wage report.
A quarterly return isn't a payment mechanism — it's a reconciliation. If you've deposited on schedule, the filing is mostly confirmation. If you haven't, the return is where the shortfall becomes official.
current IRS figure being verified: insert current quarterly due dates for Form 941 and for your state returns.
- 6
Close out the year
At year end you file the annual federal unemployment return on Form 940, issue each employee a Form W-2 and transmit copies to the Social Security Administration, and complete any state annual reconciliation. Contractors you paid generally receive a Form 1099-NEC.
Every W-2 has to agree with what you actually reported and deposited across the four quarters. That's why quarterly reconciliation matters: year-end is a summary, and a summary can't fix an error you never found.
current IRS figure being verified: insert current Form 940, W-2, and 1099-NEC deadlines, plus the current 1099-NEC reporting threshold.
- 7
Handle notices promptly
If a taxing agency sends a notice about a payroll deposit or filing, respond quickly and in writing, and keep the deposit confirmations that support your position. Most payroll notices are routine mismatches — a misapplied deposit, a name and EIN mismatch, a missing state form — and they resolve easily when addressed early.
What turns a routine notice into a serious problem is silence. Penalties and interest continue accruing while an unanswered notice sits in a drawer.
Common mistakes
Treating withheld taxes as business cash flow
Income tax and FICA withheld from employees are held in trust until deposited. Keep them in the account and treat the deposit as fixed, non-discretionary spending — failing to remit trust fund taxes carries the most severe consequences in this entire area.
Forgetting the employer share when budgeting a hire
Your true cost of employment is wages plus your share of Social Security and Medicare plus federal and state unemployment taxes, plus any state-specific employer levies. Budget the loaded cost, not the salary.
Assuming your federal deposit schedule
Deposit frequency is assigned based on your liability during a lookback period, not chosen by you, and it can change from year to year. Confirm your current schedule and calendar every due date.
Ignoring local payroll taxes
Some cities, counties, and school districts impose their own income tax withholding with separate registrations and filings. Check the locality where your employee physically works, not just the state.
Withholding for the wrong state on remote employees
Withholding generally follows where the employee performs the work, not where the company is based. Keep each employee's work location current in your payroll system and re-check it whenever someone moves.
Letting a payroll notice sit unanswered
Respond in writing as soon as a notice arrives, with deposit confirmations attached. Most payroll notices are routine mismatches that resolve easily, but penalties and interest keep accruing while they're ignored.
When to use software instead
Payroll taxes are the strongest argument for full-service payroll software. A full-service provider calculates the withholding, makes the deposits on your assigned schedule, files the quarterly returns, and produces the year-end forms — which removes the deadline-tracking burden that causes most payroll penalties.
What software does not remove is your responsibility. You still have to give the provider accurate work locations, correct W-4 information, and funded accounts, and you should still read your quarterly filings rather than assuming they're right.
If you're currently handling deposits and filings yourself, price a full-service plan against the value of the hours you spend plus the penalty risk you're carrying. For most small businesses that comparison isn't close.
Not sure which provider fits your situation? Take the free payroll quiz and we’ll point you to the shortlist that matches your answers.
Frequently asked questions
What are payroll taxes?
They fall into two buckets: taxes you withhold from your employee's pay and remit on their behalf — federal income tax, the employee share of Social Security and Medicare, and state and local income tax where applicable — and taxes your business owes as its own expense, including the employer share of Social Security and Medicare, federal unemployment tax, and state unemployment tax.
Who pays payroll taxes, the employer or the employee?
Both. Some taxes come out of the employee's gross pay and are remitted by you on their behalf, and others are an additional cost your business pays on top of wages. Unemployment taxes are generally an employer cost, though a few states also require employee contributions for programs like disability or paid family leave.
What is FICA?
FICA refers to Social Security and Medicare taxes. Both the employee and the employer contribute, Social Security applies only until the employee's wages for the year reach the Social Security wage base, and Medicare has no wage ceiling with an additional amount applying to higher earners. Confirm the current rates and wage base with the IRS, since they change annually.
How often do I have to deposit payroll taxes?
Your federal deposit frequency is assigned based on your payroll tax liability during a lookback period rather than chosen by you, and most small employers fall on one of two schedules. State deposit schedules are separate and often run on a different cadence, so confirm both.
Which payroll tax returns do I have to file?
Most employers file a quarterly federal employment tax return on Form 941, an annual federal unemployment return on Form 940, and year-end Forms W-2 for employees, plus Forms 1099-NEC for contractors. Your state generally requires its own quarterly withholding and unemployment filings and an annual reconciliation.
What happens if I don't remit the taxes I withheld?
This is the most serious payroll failure. Withheld taxes are held in trust for the employee, and failing to remit them can lead to substantial penalties and personal exposure for responsible individuals. If you're going to be short, talk to a CPA immediately rather than skipping a deposit.
The bottom line
The concepts here don't change from year to year — what changes are the rates, wage bases, and dates. Learn the structure once, and verify the numbers every January.
If you take one thing from this page: the money you withhold from your employees isn't yours. Everything else in payroll tax compliance is easier than recovering from having spent it.
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