Payroll taxes go by a few names which may include FICA taxes, OASDI taxes, Social Security taxes and Medicare taxes.
These are flat tax rates that get withheld from your paycheck and are levied on your wage income (hence “payroll taxes”). These taxes are used to fund federal programs like Social Security benefits and Medicare benefits.
I will specifically be talking about Federal payroll taxes, but there are some states with their own payroll taxes for state funded programs (e.g. Washington’s upcoming long-term care payroll tax of 0.58%).
These taxes are often forgotten about, or even unknown, because they are directly taken from your paycheck and do not get reported on an employee's tax return (unless there was a mistake with the withholding by your employer).
These taxes are calculated and assessed for each individual without regard to marital status, with the exception of the additional Medicare tax mentioned below.
This blog will be more about the mechanics of the taxes as opposed to the pros / cons of the programs that they are funding.
Social Security Tax
The first part of Federal payroll taxes helps to fund the Social Security system, also known as OASDI tax (Old Age, Survivor and Disability Insurance). This is a flat 12.4% tax on your wages up to the wage base. The wage base changes each year due to inflation, and the wage base in 2021 is $142,800.
That flat percentage of 12.4% is split between the employee and the employer - so when you look at your paystub, any wage income that you receive (except for deductions I mention below) will have 6.2% withheld for this tax.
Any wage income you make above $142,800 will not be subject to this tax. Therefore, the maximum you can pay into this system in 2021 is $8,853.60.
If you take a look at your 2020 Form W-2, box 3 will outline how much of your income last year was subject to this tax, and Box 4 will show you how much you paid in Social Security taxes.
The second part of Federal payroll taxes helps to fund the Medicare system. This is a flat percentage of 2.9% with no cap on your income. In other words, this tax is not subject to the wage base, so there is no cap as to how much of this tax you can pay.
Similar to Social Security tax, this tax is split between the employee and employer - therefore on your paystub you will be able to see that any wage income that you receive (except for deductions I mention below) will have 1.45% withheld for this tax.
One caveat with this tax is not only is there no cap to your income, but there is an added 0.9% surcharge if your income is above a certain threshold. This is called the additional Medicare tax. This threshold depends on your filing status. If you are married filing jointly, that income threshold is $250k and if you are single or head of household status, the income threshold is $200k. This 0.9% gets added on top of the 1.45% for wage income above those thresholds.
Self-employed individuals don’t have quite the same story - since there is no employer to withhold these taxes, the taxes get reported on a self-employed tax return, and these taxes are often called “self-employment tax” and is figured through the IRS Schedule SE.
The rules are the same as the employer/employee and get levied on a self-employed individual’s net income for the year. The downside for a self-employed individual is that the IRS views them as both the employee and the employer; so, employees get to split these taxes with their employer while the self-employed assumes both roles and has to pay the full 12.4% Social Security tax and the full 2.9% Medicare tax for a total of 15.3% up to the wage base.
Of course, the “employer” side of that payment is a deductible business expense, but it doesn’t take away from the fact that it still has to be paid.
Avoiding these taxes
Taxes don't always have to be viewed negatively as you are contributing to programs that are helping other individuals. Additionally, any wages on which you pay Social Security tax will get added to your Social Security earnings record - this is used to calculate your Social Security payment amount when it comes time to claim these benefits.
But there are legal ways to avoid some of these taxes which are largely through programs available through your employer. Some, but not all, include:
Health Insurance Premiums (medical, dental, vision)
Health Savings Account funding (through your employer)
Flexible Spending Account funding (both health and dependent care)
As a self-employed individual, it is much harder to avoid these taxes since you do not have employer provided programs. The best way to avoid these taxes is to ensure you are reporting all of your business expenses, as this will lower your net income that is subject to payroll taxes.
One other call out is that retirement plan contributions are not exempt from payroll taxes. Whether you do traditional pre-tax contributions or Roth post-tax contributions, either way these wages will have payroll taxes associated with them. The pre- and post-tax is specifically talking about Federal (and sometimes state) income taxes.
Potential Future Changes
I feel like most times I bring up Social Security, my peers say something along the lines of “is that even going to be around when I retire? I hear the program is almost out of money”. Although it is true that the Social Security trust fund is depleting, there are still inflows every year from the working class paying into the system (yay payroll taxes?).
Without the trust fund and just the inflows, the current program can still fund the majority of benefits; the trust fund currently pays the minority of benefits. So, this isn’t quite the question of all or nothing, but there is the possibility that when it comes time for you to claim benefits there could be a reduced amount.
And that is assuming there are no changes to the program, which I find unlikely. Some changes may be:
Increasing the tax rate or adding surtaxes to higher income (like an "additional Social Security tax")
Increasing the wage base (so more income is taxed)
Reducing Social Security benefits
Increasing the income taxes on the actual benefits
A later date at which you are eligible to claim benefits
Limiting other claiming strategies
One example is that Biden formerly proposed creating what they are calling a “donut hole” in the wage base. The proposal was to keep the same current wage base, but also assess Social Security tax for those with wage income above a $400k threshold (the donut hole in 2021 would be incomes between $142,800 and $400k would have no Social Security tax but all money earned outside of that "hole" would be assessed the tax.).
No tax changes have been passed by Biden at this point (except executive orders during COVID), and there is no guarantee that anything that has been proposed will pass. But this goes to show that others are aware of the Social Security shortfall and that there are tools that can be implemented to keep the program a long-running success.
I’ve written some LinkedIn posts about the ProPublica leak of the US’s richest individuals and how much tax they pay. The main takeaway is the stark difference between the tax rates of earned income vs. growth of wealth. These payroll taxes are just one piece of that, but still a piece. Investment, real estate, business income, etc. is not considered payroll income and therefore avoid these aforementioned taxes. On top of that, any wages earned above the wage base of $142,800 in 2021 (this is pretty low compared to high earners and the wealthy) avoid the higher Social Security tax rate of 6.2% and only pay the 1.45% (and the additional 0.9%) on most of this income.
These taxes are an expense that can add up to 7.65% of your income on top of Federal and state income taxes. Make sure you understand the implications of these taxes and any company benefits that you can utilize to avoid them - it is not just about what you make, but what you keep.