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Try It Free“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 ($184,500 in 2026) 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. However, most employers qualify for a credit of up to 5.4% for paying state unemployment taxes on time, which lowers the effective FUTA rate to 0.6%. 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 2026, nine states — Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming — do not charge a formal income tax on wages. New Hampshire fully repealed its tax on interest and dividend income in 2025, 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.
As of 2026, the following 15 states employ flat income taxes: Arizona (2.5%), Colorado (4.4%), Georgia (5.19%), Idaho (5.3%), Illinois (4.95%), Indiana (2.95%), Iowa (3.8%), Kentucky (3.5%), Louisiana (3%), Michigan (4.25%), Mississippi (4% on all income after the first $10,000), North Carolina (3.99%), Ohio (2.75% on income over $26,050), Pennsylvania (3.07%), and Utah (4.5%).
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 earns $100,000 in 2026 would calculate his or her tax liability.
Before calculating these amounts, we must establish the tax rates. Based on the IRS’s 2026 tax brackets, the federal income tax would be:
- 10% on income up to $12,400;
- 12% on income from $12,401 to $50,400;
- 22% on income from $50,401 to $105,700; and
- 24% on income from $105,701 to $201,775.
The Social Security tax rate in 2026 is 6.2% on earnings up to $184,500, and the Medicare tax rate is 1.45% on all earnings. For 2026, Michigan’s flat income tax rate is 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 $12,400 earned is taxed at 10%. ($12,400 x 0.10) = $1,240
- Earnings between $12,401 and $50,400 are taxed at 12%. ($38,000 x 0.12) = $4,560
- Earnings between $50,401 and $105,700 are taxed at 22%. ($100,000 - $50,400) x 0.22 = $10,912
Then, add each of the tax amounts together to determine the employee’s federal income tax liability. ($1,240 + $4,560 + $10,912) = $16,712
2. Social Security Tax Calculation
The Social Security tax rate in 2026 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 2026 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 Total Tax Liability
Now, we can summarize the total tax liability:
- Federal Income Tax: $16,712
- Social Security Tax: $6,200
- Medicare Tax: $1,450
- Michigan State Income Tax: $4,250
Adding all of these together gives us the total tax liability for an individual earning $100,000 in Michigan.
($16,712 + $6,200 + $1,450 + $4,250) = $28,612.
Thus, an individual earning $100,000 in Michigan would carry a total tax liability of $28,612 in 2026.
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.
Indiana: HB 1001, passed in May 2023, continues to lower Indiana’s flat individual income tax rate, which dropped from 3% in 2025 to 2.95% in 2026. A further reduction to 2.9% is scheduled for 2027.
Kentucky: Kentucky's flat individual income tax rate reduced from 4% in 2025 to 3.5% starting in 2026, after a revenue-triggered reduction approved in 2025.
Mississippi: The state’s tax rate decreased from 4.4% to 4% on taxable income exceeding $10,000 in 2026.
Montana: Montana lowered its top individual income tax rate from 5.9% to 5.65% in 2026, with a further reduction to 5.4% planned for 2027.
Nebraska: Nebraska lowered its top individual income tax rate from 5.2% in 2025 to 4.55% in 2026. That rate is set to gradually reduce to 3.99% by 2027.
North Carolina: North Carolina's flat individual income tax rate reduced from 4.25% to 3.99% in 2026.
Ohio: Starting in 2026, Ohio moved from a top rate of 3.125% to a flat tax of 2.75% on income over $26,050.
Oklahoma: Oklahoma reduced its top individual income tax rate from 4.75% to 4.5% in 2026 and consolidated its six brackets into three.
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!
Frequently Asked Questions
What is the difference between payroll taxes and income taxes?
Payroll taxes are contributions toward Social Security, Medicare, and unemployment insurance, which both employees and employers pay. Income taxes, on the other hand, are based on an individual's or business's earnings and are solely the responsibility of the employee, though employers withhold and remit the taxes on their behalf.
Are payroll taxes the same in every state?
No, payroll taxes can vary depending on state laws. For example, state unemployment tax (SUTA) rates differ across states, and some states may impose additional payroll taxes.
Which payroll taxes are paid by employers?
Social Security tax, Medicare tax, Federal Unemployment Tax (FUTA), and State Unemployment Tax (SUTA).
Do employers pay income tax?
Employers do not pay income tax on behalf of employees, but they are responsible for withholding and remitting the correct amount of income tax from employee wages to the relevant tax authorities.
What is FICA, and why is it important?
FICA stands for Federal Insurance Contributions Act, and it refers to the taxes that fund Social Security and Medicare programs. Both employees and employers are required to contribute to FICA, ensuring the funding of these essential social safety nets.
What is FIT Tax?
The acronym FIT refers to Federal Income Tax or the tax the federal government imposes on income earned by individuals and businesses. For employees, FIT is the amount of federal income tax withheld from their paychecks by their employer, based on the employee's income, filing status, and the dependents, other income, deductions, and extra withholding reported on their W-4 form.
How are state income taxes different from federal income taxes?
State income taxes are imposed by individual states and vary widely in rates and structures, including flat and progressive tax systems. Federal income taxes are imposed uniformly across all states, with a progressive tax rate based on income levels.
Are there any states without income taxes?
Yes, there are nine states — Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming — that do not charge a personal income tax on wages. However, Washington does tax capital gains income.
How do changes in tax laws affect payroll?
Changes in tax laws, such as adjustments to tax rates, brackets, or deductions, directly impact payroll by altering how much employees need to withhold from their paychecks and how much employers must match in payroll taxes. Staying up-to-date with these changes is crucial to ensure compliance.
What are the penalties for incorrect payroll tax withholding?
Failure to correctly withhold payroll taxes can result in penalties, fines, and interest charges from the IRS or state tax authorities. These penalties can be severe and cause significant financial strain for businesses.
How can businesses simplify payroll tax compliance?
Using workforce management software, like OnTheClock, can help automate tax calculations, time tracking, and payroll processes, reducing administrative burdens and minimizing errors. Automation ensures businesses stay compliant with changing tax regulations.
Do flat taxes mean everyone pays the same amount in taxes?
No, flat taxes mean everyone pays the same tax rate, regardless of their income. However, the total amount each individual pays still depends on their taxable income.
Where Do My Tax Funds Go?
Payroll taxes are specifically designated to fund social insurance programs like Social Security, Medicare, and unemployment insurance. These programs provide safety nets for retirement, health care, and temporary unemployment assistance. Income taxes, in contrast, fund a wide range of government services, such as national defense, education, infrastructure, and other public services. Income taxes also vary by federal, state, and local governments.
