Accurately calculating employee taxes is one of the most important responsibilities of any business that processes payroll. It affects everything from employee take-home pay to your company’s compliance with local, state, and federal tax laws. Missteps can lead to costly fines, payroll errors, or even audits.
This article walks you through how employee tax calculations work, the key components involved, and why understanding your payroll costs—including payroll as a percentage of revenue—can give you clearer insight into the financial health of your business.
What Are Employee Taxes?
Employee taxes refer to the required deductions and contributions that employers must withhold from employee paychecks, as well as the taxes the business itself must pay on behalf of its employees. These taxes fund programs like Social Security, Medicare, unemployment insurance, and income tax withholding.
There are two main categories of employee taxes:
- Employee Withholdings: These are amounts deducted directly from the employee’s paycheck.
- Employer Contributions: These are taxes the business must pay in addition to wages.
Let’s take these two categories and break them down further.
Taxes You Must Withhold from Employees
As an employer, you’re responsible for calculating and withholding the following taxes from each paycheck:
- Federal Income Tax: Based on the employee’s W-4 form and IRS withholding tables. This amount varies based on earnings, marital status, and number of allowances.
- FICA Taxes: Inclusive of:
- Social Security Tax: 6.2% of gross wages (up to the annual wage limit).
- Medicare Tax: 1.45% of gross wages. Wages over $200,000 may require an additional 0.9%.[1]
- State Income Tax: Applies in most states and is determined by your state’s tax rates.
- Local Taxes: Some municipalities or counties levy additional payroll taxes.
- Other Voluntary Deductions: Health insurance, retirement contributions, and other benefits that may affect taxable income.
It’s crucial to use up-to-date tax tables and follow the latest IRS and state guidelines to ensure accuracy.
Employee Taxes Paid By Employer
In addition to the amounts you withhold from employees, your business must also budget for employer-paid payroll taxes, including:
- Employer Share of FICA: You match the employee’s Social Security and Medicare contributions (6.2% and 1.45% respectively).
- Federal Unemployment Tax (FUTA): Typically 6.0% on the first $7,000 of wages per employee. Many businesses qualify for a credit that reduces this to 0.6%.
- State Unemployment Tax (SUTA): Varies by state and by your business’s experience rating.
- Workers’ Compensation Insurance: Required in most states and based on industry and payroll size.
How to Calculate Employee Taxes: A Step-by-Step Guide
Calculating employee taxes correctly means understanding both gross pay and applicable deductions. Here’s a simplified walkthrough:
Step 1: Determine Gross Pay
Gross pay includes:
- Regular wages or salary
- Overtime
- Bonuses or commissions
- Paid time off
Step 2: Calculate Pre-Tax Deductions
Subtract pre-tax contributions such as:
- Health insurance premiums
- Retirement plan contributions (e.g., 401(k))
- HSA or FSA contributions
These reduce the taxable income amount.
Step 3: Apply Federal Withholding
Use the IRS’s current withholding tables or a payroll software tool to determine the correct amount of federal income tax to withhold, based on the employee’s Form W-4.
Step 4: Calculate FICA Taxes
Multiply the employee’s taxable wages by:
- 6.2% for Social Security (up to wage base limit)
- 1.45% for Medicare
Don’t forget to match this amount as the employer.
Step 5: Calculate State and Local Taxes
Check your state’s department of revenue site or use payroll software to apply the correct state income and unemployment tax rates. The same goes for any applicable local or city taxes.
Step 6: Total Employer Contributions
In addition to matching FICA, include FUTA, SUTA, and workers’ compensation premiums in your calculations.
Step 7: Double-Check and Remit Payments
Once calculations are complete, make sure to remit withholdings and contributions to the appropriate agencies on time. Most businesses file quarterly using IRS Form 941 and annually using Form 940 for FUTA.
What About Contractors?
Independent contractors are responsible for paying their own taxes, so you do not withhold taxes from their payments. However, you must report contractor payments of $600 or more annually using Form 1099-NEC.
Misclassifying employees as contractors can trigger penalties and back taxes, so establish processes to help ensure you classify workers correctly.
Payroll as a Percentage of Revenue: A Key Metric to Monitor
Calculating taxes is about more than compliance—it’s also essential for tracking payroll costs as a portion of your company’s revenue. This metric gives insight into the financial sustainability of your staffing model.
Why It Matters
- Helps with budgeting and forecasting
- Identifies potential overspending
- Benchmarks your labor costs against industry averages
How to Calculate It
You can get the simple, repeatable formula in our What Percent of Gross Revenue Should Go to Payroll? Guide.
Avoiding Common Payroll Tax Pitfalls
When it comes to employee tax calculations, a few common issues tend to cause the most trouble:
- Incorrect W-4 data: Always keep employee tax information up to date.
- Outdated tax tables: Rates change annually—be sure your calculations reflect current rules.
- Manual errors: Small typos in spreadsheets can result in large discrepancies.
- Late tax deposits: These can result in fines or interest charges.
Ensure the individual(s) in charge of payroll at your organization are aware of these common mistakes and that your payroll toolset accounts for them as much as possible.
How Payroll Software Helps
Using a payroll solution like Paypro eliminates the guesswork from tax calculations. Key benefits include:
- Automatic updates to tax tables and rates
- Built-in calculations for withholdings and contributions
- Filing reminders and automated payment features
- Compliance reports and audit trails
With automation, your business can reduce errors, save time, and stay fully compliant—giving you peace of mind every pay cycle.
Employee tax calculations are a critical part of running a compliant and financially healthy business. When done correctly, they ensure your team gets paid accurately, your business stays in good standing with tax authorities, and your payroll costs stay within budget.
From understanding what to withhold, to calculating your own tax obligations, every step matters. And with modern payroll software, the process doesn’t have to be complicated.
Paypro helps businesses of all sizes streamline their payroll processes, stay tax-compliant, and gain greater control over labor costs. If you’re ready to take the stress out of payroll tax calculations, reach out to Paypro today—we’ll help you handle your responsibilities with confidence.
[1] Referring to the 1.45% withheld from employee wages in addition to the 1.45% employer is directly responsible for.