Unemployment compensation tax is the collective name for the payroll taxes that finance the joint federal-state unemployment insurance system in the United States. The system pays temporary benefits to eligible workers who lose their jobs through no fault of their own. Employers pay two layers of tax: the federal unemployment tax (FUTA) and a state unemployment tax, often called SUTA or state unemployment insurance (SUI) tax.
Unlike Social Security and Medicare tax, unemployment taxes are generally paid only by employers and are not withheld from employees' pay. Alaska, New Jersey and Pennsylvania are exceptions, requiring small employee contributions to state unemployment funds. For employers, unemployment taxes are part of employer payroll taxes and an expense of employing staff.
How the federal and state taxes fit together
- FUTA is levied at 6.0 percent on the first $7,000 of wages paid to each employee in a calendar year. Its revenue pays for administering the system in every state, a share of extended benefits during recessions, and loans to states whose funds run short.
- Employers receive a credit of up to 5.4 percent against FUTA for state unemployment taxes paid on time to a state with an approved program, reducing the effective federal rate to 0.6 percent, or $42 per employee per year.
- If a state has borrowed from the federal government and not repaid the loan within the required time, its employers face a credit reduction, which raises their effective FUTA rate for that year.
- SUTA rates and wage bases are set by each state. Wage bases range from the federal minimum of $7,000 to well over $50,000 in some states, and rates vary from well under 1 percent to above 10 percent.
Experience rating
State unemployment tax rates are experience rated. An employer whose former employees have drawn few benefits gets a lower rate, while one with frequent layoffs and many claims pays more. New employers are usually assigned a standard rate for their first years until they build a claims history. Industries with seasonal or volatile employment, such as construction, agriculture and tourism, tend to pay higher rates because seasonal workers often claim benefits between jobs. This gives employers a financial reason to avoid unnecessary layoffs and to contest invalid claims.
Worked example and accounting
A small business in a state with a $9,000 wage base and an assigned SUTA rate of 2.7 percent employs four people for the full year, each earning more than $9,000. State tax is 4 times $9,000 times 2.7 percent, or $972. FUTA, after the full 5.4 percent credit, is 4 times $7,000 times 0.6 percent, or $168. Total unemployment tax for the year is $1,140, all paid by the employer.
Because both taxes apply only up to the wage base, most of the cost falls in the first months of the year, when each employee's wages are still below the limit. Each payroll, the employer debits payroll tax expense and credits FUTA payable and SUTA payable, which are included in payroll taxes payable among current liabilities until paid. FUTA is deposited quarterly once the liability exceeds $500 and reported annually on Form 940 to the Internal Revenue Service. State taxes are usually paid and reported quarterly, along with wage details for each employee.
Policy context
Unemployment insurance was created by the Social Security Act of 1935 and acts as an automatic stabilizer: benefits rise when unemployment rises, supporting spending during downturns. The $7,000 FUTA wage base has not changed since 1983, which means the federal tax has become a much smaller share of wages over time. During severe recessions, many state trust funds have run out of money and borrowed from the federal government, leading to FUTA credit reductions and higher state rates in later years. Some types of workers and employers are exempt, including many nonprofit organizations, which may reimburse the state for benefits paid instead of paying tax, and certain family and agricultural employment below set thresholds. More broadly, unemployment taxes are one of several payroll taxes that add to the total cost of employment beyond gross wages.