Income tax, whether federal, state, or city, is based on your taxable (or net) income. That's the amount that remains after your deductions and exemptions have been subtracted from your gross income. Payroll taxes—most notably Social Security and Medicare, often referred to in combination as FICA—are levied on your gross income.
FICA requires that your employer withhold 6.2 percent of your gross income for Social Security and 1.45 percent for Medicare, for a total of 7.65 percent. However, last year Congress voted to temporarily lower the Social Security portion to 4.2 percent for all of 2011, and at the last minute it renewed that break for the first two months of 2012. (As it's an election year, it's highly likely that the break will ultimately be extended for all of 2012.) Therefore, your employer must withhold 5.65 percent of every dollar you get paid. On $100 in gross salary, that means $5.65 taken from your check for FICA payments.
The good news is that Social Security withholding stops once your income hits $110,100. But if you work for more than one employer, each one must continue the withholding until your income from that employer reaches $110,100. Fortunately, the excess is treated as federal withholding tax, and you can usually get it back as a refund.
In the case of Medicare, however, there is no income limitation. The money just keeps disappearing from your check no matter how much you make.
But there's an additional wrinkle to payroll taxes, one that many people aren't aware of: Your employer must also pay a contribution. This amounts to an additional 7.65 percent of your gross income (again, 6.2 percent for Social Security and 1.45 percent for Medicare). Therefore, between your contribution as the employee (5.65 percent) and your employer's share (7.65 percent), the total FICA tax payment to the government is equal to 13.3 percent of your gross income.
Because employers want to avoid such costs, they increasingly pay those working for them not as regular employees but as "independent contractors." This means they pay you in "cash," with no tax deductions taken out at all. That way, they not only avoid paying that 7.65 percent; they also escape paying unemployment, disability, and health care costs.
In the eyes of the Internal Revenue Service, independent contractors are legally considered both employee and employer, which means you become responsible for paying the full 13.3 percent as a "self-employment tax," though it's based on your net income, not your gross. Still, 13.3 percent of your net is a lot more than 5.65 percent of your gross.
Independent contractors are supposed to estimate how much they will owe in taxes and pay it in advance in quarterly installments. It's the equivalent of having an employer take withholding taxes out of your check. If you haven't anticipated your taxes as an independent contractor, you can find yourself with a huge tax burden at the bottom of your return. And that's why it's important to fully understand payroll taxes.