Payroll Tax vs. Income Tax: What's the Difference Between Them?

Payroll Tax vs. Income Tax: What's the Difference Between Them?
Payroll Tax vs. Income Tax: What's the Difference Between Them?
Taxes are amounts taken from citizens or businesses to be used as needed by the government. The government has the power to force people to pay these taxes or face some kind of penalty or legal repercussions.

Income tax and payroll tax are both taxes that affect almost every working individual in the U.S. No matter what job you hold or what hours you work, there's a good chance you're subject to withholdings for these taxes each time you're paid.

Though they both involve paying the government money, income tax and payroll tax are two distinct types of taxes.

While payroll tax is typically referred to as FICA tax, it consists of two distinct components: Social Security tax and Medicare tax. In contrast, income tax results in withholdings that go towards a number of different government-run programs.

Purpose of Payroll and Income Taxes

The government is constantly trying to raise money to meet its expenses. There are two main purposes for government spending: to supply the goods and services that the community wants but which markets alone would not supply (like law and order, roads, education, and public health), and to help people who are in need, who cannot support themselves, or whose incomes or resources are insufficient to enable them to live a decent human life.

These functions are obviously very important, but they are costly. To meet the necessary expenses, the government or public sector must "raise money." Most countries and their citizens depend on the government to provide these goods and services.

Generally, there are two main ways in which the government raises money for the public sector: either through making charges (like bus fares, university fees, a national lottery, or taxes) or through regulatory tariffs or licenses. For most goods or services, however, the government supplies the required funds from its tax revenue.

Payroll Tax vs. Income Tax Explained

We can't talk about payroll and income taxes without knowing their meaning. So for people who don't know the definitions, we will break it down below.

Meaning of Payroll Tax

Payroll tax is a tax that is akin to an income tax and is levied as a lump sum or rate on the current payroll of a business. It is assessed by the tax authorities. It differs from employment taxes in that employment taxes are paid by the employees out of their wages and are therefore not part of business costs.

The employer's share in an employment tax is part of the normal tax base for income tax in the formal economy. In simple terms, payroll tax is a tax on gross business revenue from current contributions of labor to production in the business being taxed.

These workers may be called employees of formal-economy businesses. They are in the database of the labor authorities.

Have you heard about payroll tax settlement? Do you know what it means? Well, if you are hearing about it for the first time or don't know its meaning, payroll tax settlement is the process of reconciling and settling the amounts of payroll taxes that a business owes to the government.

Meaning of Income Tax

To put it in simple terms and not confuse you with big words, income tax is a tax that governments charge on the earnings or profits of individuals and businesses in their jurisdiction. It is a direct tax, meaning it is paid directly by the individual or entity earning the income.

We can calculate income tax as a percentage of an individual's taxable income (salary and wages from our jobs, self-employment income, interest, and dividends), capital gains (from selling assets), and income from rent and royalty.

Honestly, the income tax rates for a working person depend on their filing status, earnings, and the tax laws of their country or state. The revenue generated from income tax is used to fund public goods and services, such as infrastructure, education, healthcare, and social welfare programs.

Income tax is usually paid through pay-as-you-earn (PAYE) systems (where employers deduct tax from employee salaries), self-assessment (where individuals declare their income and pay tax annually), withholding tax (where tax is deducted from interest), dividends, and other income sources.

The main purpose of income taxes is to redistribute wealth, fund public expenditures, and influence economic behavior. You can consult with the right professional income tax advisor for more information about it.

This will bring us to something called “intent to levy.” So what does intent to levy mean?

An "intent to levy" or “notice of intent to levy” is a notice issued by tax authorities to inform a taxpayer of their intention to seize the taxpayer's property or assets to satisfy an outstanding tax debt. It is a warning that the tax authorities are planning to take action to collect the unpaid taxes.

Payroll Tax vs. Income Tax: Differences Between Payroll Tax and Income Tax

The key differences between payroll tax and income tax to consider are the following:

1. Definition and Scope

Payroll taxes are taxes paid on the wages and salaries of workers. Most wages get taxed, although there are some deductions and exclusions, such as those for contributions to savings plans and health insurance.

Social Security taxes, Medicare taxes, and Federal Unemployment taxes are the primary payroll taxes. Payroll taxes are levied by the federal government and by state governments (which are called state unemployment taxes and are part of the Federal Unemployment Tax).

In contrast to the payroll tax, there are also income taxes, which are usually withheld along with payroll taxes. Income taxes are the main revenue source for the federal government.

They are levied on wages and salaries, as well as on dividends, interest, and other sources of non wage income. The tax rates are progressive, with increasing marginal rates for higher incomes.

2. Collection Process

The income tax is collected at source, which means that it is deducted from the wages paid by employers. Employers are generally licensed by the tax administration to withhold tax from wages paid to employees.

Employers withhold the tax and remit it to the tax administration. This process is based on the principle of withholding, which ensures that the amount of income tax collected is an accurate reflection of the actual amount that a taxpayer should pay. The tax is paid by individuals, and no intervention is required from them.

The payroll tax is also collected through this withholding mechanism. However, the difference with the income tax is that the payroll tax is collected by employers from workers, who cover the cost of much of the tax by paying lower wages.

The employer is the legal payer of the tax; however, the employer has agreed with the employee to bear the cost of some of it by paying wages that are lower than the marginal value of workers' services.

This collection through wages makes the collection of the payroll tax worse than the collection of the income tax.

3. Taxable Entities

A crucial distinction between the payroll tax and the personal income tax is the entity that is obligated to pay the tax. The payroll tax is divided between the employer and the employee, whereas the personal income tax is levied on both employed workers and the self-employed.

Consequently, employed workers are subject to both taxes. By contrast, a self-employed entity is liable only for the personal income tax, while workers whose employers don't make payroll tax deductions are solely liable for the payroll tax.

The combination of both forms of wage-based taxation reduces the labor wedge in a particular country. This equality is not ordained, however.

4. Taxable Income Base

The basic difference between payroll and income tax is in the base to which a tax rate applies. Income tax applies to some measure of an individual's income, and the rate is the same no matter whether the individual is employed, running a business, or making capital gains.

The base to which the tax applies is known as either the tax base or taxable income. Ideally, the tax base of an income tax should, therefore, include all sources of monopoly profit and all income from any source as much as possible.

The tax base of a payroll tax is more restrictive, generally limited to labor income, although several payroll taxes in a few countries are levied on a wider income base.

Employment-based payroll taxes are imposed on both employers and employees, while independent payroll taxes are imposed on the self-established accounting income base as advanced by business taxpayers.

5. Method of Calculation and Rate Structure

Payroll tax funds Social Security and Medicare, with both employees and employers paying a percentage of wages (1.45% for Medicare and 6.2% for Social Security).

Income tax, on the other hand, funds general government operations and services. It's calculated based on total earnings after deductions and applies different rates depending on income levels.

What I am saying in essence is that while payroll taxes are fixed percentages of your wages, income taxes are progressive, meaning the more you earn, the higher the tax rate you pay.

Conclusion: Compare Payroll Tax and Income Tax

Payroll tax and income tax are different kinds of levies that businesses in the United States withhold from employees' paychecks each pay period for various tax and insurance purposes.

On the one hand, payroll taxes are paid by employees and employers into accounts like retirement and unemployment funds, such as Social Security, Medicare, Medicaid, and workers' compensation.

On the other hand, income taxes, often referred to as federal or state income taxes, are deducted from employees' earnings during each pay period and other personal income.

If you are still struggling with income and payroll taxes or need help from trusted tax experts, you can always contact the best IRS tax professionals to help solve whatever issues you have.
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