Unemployment Insurance (UI) is a joint federal and state program designed to provide a temporary financial safety net for workers who lose their jobs through no fault of their own, such as during a layoff. The funding mechanism for this program is primarily a mandatory payroll tax paid directly by employers. This tax ensures that funds are available to provide wage replacement to involuntarily unemployed workers while they search for new employment.
The Short Answer: Employer Liability
Employers are solely responsible for paying the taxes that fund the vast majority of the unemployment insurance system across the United States. These payments are not deducted from an employee’s gross wages, meaning the tax liability rests entirely with the business. This funding is handled as a mandated payroll tax, calculated based on a percentage of each employee’s wages up to a certain taxable limit.
The employer pays these contributions into a dedicated state fund, which is then used to pay benefits to eligible former employees. The employer does not pay the benefits directly to the laid-off worker. Instead, the state’s unemployment agency administers the fund and distributes the payments, drawing from this collective insurance pool.
Federal and State Funding Structures
The unemployment system operates under a two-part funding structure involving both federal and state taxes. The federal component is governed by the Federal Unemployment Tax Act (FUTA). FUTA taxes are paid by employers to the federal government and are used to provide administrative funding for state UI programs, as well as to finance extended benefits during periods of high unemployment.
The standard FUTA tax rate is 6.0% on the first $7,000 of wages paid to each employee annually. Employers who pay their state unemployment taxes in full and on time are generally eligible to receive a federal tax credit of up to 5.4%. This credit effectively reduces the FUTA tax rate for most employers to a net 0.6%.
The primary source of actual benefit payments comes from the state level, known as State Unemployment Tax Act (SUTA) or State Unemployment Insurance (SUI). SUTA taxes are collected by individual state labor departments and are the main source of the funds used to pay weekly benefits to eligible claimants. The tax rate and the taxable wage base vary widely from state to state. This variation is due to each state setting its own rules based on its economic conditions and the solvency of its unemployment fund.
How Employer Tax Rates Are Determined
The specific SUTA tax rate an individual employer pays is determined by a mechanism known as “experience rating.” This system is designed to distribute the cost of unemployment among businesses based on their recent history of layoffs and employee turnover. The experience rating essentially functions like a personalized insurance premium.
An employer’s rate directly correlates with the amount of unemployment benefits successfully claimed by their former workers. Businesses with a high number of former employees drawing benefits will see their experience rating increase, resulting in a higher SUTA tax rate. Conversely, companies that maintain a stable workforce and have few successful claims against them are assigned a lower tax rate.
States calculate this experience rating using various methods, often involving a “reserve ratio” or “benefit ratio.” This calculation compares the employer’s contributions to the fund against the benefits paid out to their former workers over a specific period. New employers, who do not yet have a history of claims, are typically assigned a standard, non-experience-rated introductory rate for a set period, which varies by state.
Employee Contributions: The State Exceptions
While the unemployment insurance system is overwhelmingly funded by employer-paid payroll taxes, a small number of states require a contribution from the employee. Employees in Alaska, New Jersey, and Pennsylvania are required to contribute a small percentage of their wages to the state’s unemployment fund.
These employee contributions are generally taken as a payroll deduction, similar to other withholdings. The money collected contributes to the overall state unemployment pool. This structure remains the exception, as the national standard places the financial burden of the UI system squarely on employers.
Illegal Employer Practices Regarding Unemployment Funding
It is strictly illegal in nearly all states for an employer to attempt to deduct their required FUTA or SUTA contributions from an employee’s wages. These are legally mandated employer taxes, and passing the cost of the employer’s liability onto the worker is a violation of state law. Employees who suspect their employer is improperly deducting these taxes should report the activity to their state labor department.
Employers also face penalties for misclassifying employees as independent contractors to avoid paying UI taxes. Worker misclassification is a common tactic used to evade UI contributions and other payroll taxes. States are aggressively pursuing businesses that engage in this practice, often recovering unpaid contributions and imposing substantial fines and interest. Employers can also face fines and increased tax rates if they fail to respond timely or adequately to state agency notices regarding a former employee’s unemployment claim.