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What is Federal Unemployment Tax (FUTA) and FUTA Credit Reduction?

The Federal Unemployment Tax Act (FUTA) is a federal payroll tax paid by employers that, along with state unemployment tax systems (SUTA), funds unemployment benefits for workers who lose their jobs. The FUTA tax system is a federal-state partnership, with the federal portion covering administrative costs for state unemployment agencies, half the cost of extended benefits during periods of high unemployment, and providing loans to states that need to borrow to pay benefits.

Who pays FUTA tax?

FUTA tax is paid only by employers and is not withheld from employee wages. Generally, employers must pay FUTA tax unless they meet criteria to be considered exempt from the tax. Exemptions include 501(c)(3) non-profit companies, and wages paid to dependents of sole proprietors under age 21.

FUTA vs. FICA: Key differences

FUTA and FICA (which funds Social Security and Medicare) differ in their purpose, who pays them, and how they are calculated. While FUTA is a tax only on employers, FICA is a matching tax on both employees and employers.

How is FUTA tax calculated?

The standard FUTA tax rate is 6.0% on the first $7,000 of wages per employee annually. Employers can typically claim a credit of up to 5.4% for timely state unemployment tax payments, resulting in a net FUTA rate of 0.6%. Employers must deposit FUTA tax quarterly if their liability exceeds $500 and file an annual report using Form 940.

What is FUTA credit reduction?

A FUTA credit reduction (FUTA CR) reduces the amount of the FUTA credit described above, increasing an employer's net FUTA tax rate in states that have outstanding federal loans for unemployment benefits. These are referred to as "credit reduction states". The credit reduction exists to encourage states to repay federal loans and help maintain the stability of the federal unemployment fund.

How is FUTA credit reduction calculated?

The U.S. Department of Labor designates credit reduction states annually. If a state has an outstanding loan for two consecutive years, the FUTA credit is reduced annually by at least 0.3% until the loan is repaid. This reduction affects the employer's effective FUTA tax rate and is calculated on Form 940, Schedule A. Each year a state is in credit reduction status, the reduction amount increases by 0.3%. So, in the first year of credit reduction, the additional tax is 0.3%, 0.6% in the 2nd year, 0.9% in the third, and so on. States have until November 10th each year to complete repayment of their loans, thus credit reduction states cannot be determined until that date each year. Additional tax amounts for each year are due in January of the following year.

Budgeting for FUTA Credit Reduction

Federal Unemployment Loans to states and predictions for which states will be in credit reduction status each year can be found on the internet. If your state is predicted to be in FUTA Credit Reduction status, it is a good idea to set aside amounts for the tax each pay period. To calculate the amount to set aside, multiply the total gross pay each period by the FUTA CR rate for the year. If you do this each pay period, you will better be able to manage the effect of this tax on cash flow at the end of the year.