What Is Federal Unemployment Tax Act (FUTA)?
The Federal Unemployment Tax Act (FUTA) is a United States federal law that imposes a payroll tax on employers to help fund state workforce agencies and provide unemployment benefits to workers who have lost their jobs. It falls under the broad category of taxation, specifically as a component of the social insurance system. FUTA works in conjunction with state unemployment tax systems to ensure a financial safety net for eligible individuals during periods of joblessness. Employers report this tax by filing IRS Form 940 annually.
History and Origin
The Federal Unemployment Tax Act (FUTA) emerged as a critical piece of legislation during the Great Depression, specifically as part of the broader Social Security Act of 1935. This landmark act aimed to establish a national system of social insurance to protect Americans from economic hardship. Unemployment insurance, supported by FUTA, was designed to provide temporary financial assistance to those unemployed through no fault of their own. The legality of FUTA was later affirmed by the Supreme Court, solidifying its role in the federal-state unemployment insurance program.8 The program functions as an automatic stabilizer for the economy, providing a counter-cyclical tool during economic downturns to help stabilize purchasing power and speed recovery.7
Key Takeaways
- The Federal Unemployment Tax Act (FUTA) is a federal payroll tax paid by employers to fund unemployment benefits and state workforce agency administration.
- The standard FUTA tax rate is 6.0% on the first $7,000 of wages paid to each employee annually.
- Employers can receive significant tax credits for timely payments to state unemployment tax programs, often reducing their effective FUTA tax rate.
- The tax is reported annually to the Internal Revenue Service (IRS) using Form 940.
- FUTA is a crucial component of the federal-state unemployment insurance program, providing a financial safety net for eligible unemployed workers.
Formula and Calculation
The Federal Unemployment Tax Act (FUTA) tax is calculated based on a percentage of the taxable wages paid to each employee, up to a certain wage base limit.
The standard FUTA tax rate is 6.0%. This rate applies to the first $7,000 in wages paid to each employee during a calendar year, which is known as the federal unemployment taxable wage base.
The basic formula for calculating FUTA tax before credits is:
Where:
- Taxable Wages = The portion of an employee's annual wages subject to FUTA tax (up to the first $7,000 per employee).
- FUTA Tax Rate = Typically 0.06 (or 6.0%).
However, employers can usually claim a credit against their federal unemployment tax for contributions paid into state unemployment insurance programs. This credit can be up to 5.4%, effectively reducing the FUTA tax rate to 0.6% (6.0% - 5.4%) for employers who pay their state unemployment taxes in full and on time.6
Therefore, the effective FUTA tax calculation for most employers is:
For example, if an employer pays an employee $7,000 or more in a year and qualifies for the maximum credit, the effective FUTA tax for that employee would be:
Interpreting the Federal Unemployment Tax Act (FUTA)
The Federal Unemployment Tax Act (FUTA) primarily represents an employer-only tax liability. This means that employers, not employees, are responsible for paying FUTA taxes. The purpose of this tax is to contribute to a federal fund that supports the administration of state unemployment insurance programs and provides a federal share of extended unemployment benefits during periods of high unemployment.
Understanding FUTA involves recognizing that while the federal rate is 6.0% on the first $7,000 of an employee's wages, the actual amount an employer pays is typically much lower. This reduction is due to tax credits granted for contributions to state unemployment systems, often bringing the effective rate down to 0.6%. Employers must accurately calculate their FUTA tax and report it to the Internal Revenue Service (IRS) on Form 940, the Employer's Annual Federal Unemployment (FUTA) Tax Return.5 The ability to claim these credits depends on timely payment of state unemployment taxes.
Hypothetical Example
Consider "Alpha Retail Co.," a small business in a state that is not a credit reduction state. In a calendar year, Alpha Retail Co. employs three individuals: Alex, Bailey, and Chris.
- Alex: Earns $30,000 in wages during the year.
- Bailey: Earns $8,000 in wages during the year.
- Chris: Earns $5,000 in wages during the year.
The FUTA tax applies to the first $7,000 of wages for each employee. Since Alpha Retail Co. is in a non-credit reduction state and pays its state unemployment taxes on time, it qualifies for the maximum 5.4% FUTA tax credit, resulting in an effective FUTA rate of 0.6%.
Here's the calculation for each employee:
- Alex: $7,000 (taxable wages) × 0.006 = $42.00
- Bailey: $7,000 (taxable wages) × 0.006 = $42.00
- Chris: $5,000 (taxable wages) × 0.006 = $30.00 (since Chris's total wages are less than $7,000, only the actual wages are taxable for FUTA)
Alpha Retail Co.'s total annual FUTA tax liability for these three employees would be:
$42.00 (Alex) + $42.00 (Bailey) + $30.00 (Chris) = $114.00
This total amount is what Alpha Retail Co. would report and remit to the Internal Revenue Service (IRS) via Form 940, typically by January 31st of the following year, with quarterly deposits if the total FUTA tax liability exceeds $500 for the year.
Practical Applications
The Federal Unemployment Tax Act (FUTA) plays a vital role in the national unemployment insurance system, directly impacting how employers manage their payroll tax obligations and how unemployment benefits are funded. For businesses, complying with FUTA involves accurate calculation of taxable income and timely filing of Form 940, the Employer's Annual Federal Unemployment (FUTA) Tax Return. Th4e revenue generated by FUTA is used by the U.S. Department of Labor to provide a federal share of unemployment benefits and to cover the administrative costs of state workforce agencies.
T3his ensures that state unemployment programs have the necessary resources to process claims and provide financial assistance to eligible workers. FUTA also provides a fund from which states can borrow if their state unemployment trust funds become depleted during economic downturns, highlighting its regulatory and supportive function within the broader economic framework. The Internal Revenue Service provides detailed guidance on FUTA requirements, including those for special circumstances like domestic employers.
#2# Limitations and Criticisms
While the Federal Unemployment Tax Act (FUTA) is a cornerstone of the U.S. unemployment insurance system, it does have certain limitations and areas that draw criticism. A significant point of concern arises with "credit reduction states." These are states that have borrowed money from the federal government to pay unemployment benefits and have not repaid those loans in a timely manner. In such states, employers receive a reduced FUTA tax credit, meaning their effective FUTA tax rate increases, leading to higher tax burdens for businesses in those regions. Th1is can disproportionately impact employers in states hit hard by economic downturns, potentially hindering their recovery efforts.
Another aspect is the fixed wage base of $7,000. Critics argue that this relatively low wage base, unchanged for many years, results in FUTA revenue not keeping pace with the rising costs of unemployment benefits, especially during severe economic downturns. This can place greater reliance on state unemployment taxes or lead to increased borrowing from the federal government. The structure of FUTA also means it does not cover all types of employment, with certain industries or types of employer (e.g., some non-profit organizations or certain agricultural employers) being exempt or subject to different rules.
Federal Unemployment Tax Act (FUTA) vs. State Unemployment Tax Act (SUTA)
The Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA) are both critical components of the unemployment insurance system in the United States, yet they operate at different governmental levels and serve distinct purposes. FUTA is a federal tax, uniformly applied across all states (though adjusted by credits), with its revenue primarily funding the administration of state unemployment programs and providing a federal share of extended unemployment benefits. It is reported annually to the Internal Revenue Service (IRS) via Form 940.
In contrast, SUTA refers to the individual unemployment tax laws and rates established by each state. These state-level taxes are the primary source of funding for regular unemployment benefits paid to eligible individuals within that state. SUTA rates vary significantly by state and are often experience-rated, meaning an employer's specific SUTA rate can fluctuate based on the number of former employees who collect unemployment benefits. While FUTA allows for a substantial tax credit for SUTA payments, it's crucial for employers to understand and comply with both federal FUTA and their specific state SUTA requirements.
FAQs
What is the primary purpose of the Federal Unemployment Tax Act (FUTA)?
The main purpose of the Federal Unemployment Tax Act (FUTA) is to fund the administration of state unemployment benefits programs and to provide a federal share of benefits during periods of high unemployment. It acts as a foundational element of the broader federal-state unemployment insurance system.
Who pays FUTA tax?
Only employers pay FUTA tax. It is not deducted from an employee's wages.
How often do employers need to file FUTA taxes?
Employers generally file their FUTA tax return (Form 940) once a year. However, if their FUTA tax liability for a calendar year exceeds $500, they are typically required to make quarterly deposits.
Can FUTA tax rates change?
While the statutory FUTA tax rate has remained at 6.0% for the first $7,000 of wages, the effective rate an employer pays can change. This is primarily due to the availability of tax credits for state unemployment tax contributions and whether a state is designated as a "credit reduction" state.