When your paycheck doesn’t match the number of hours you’ve worked times your hourly wage, it doesn’t automatically mean your employer is stealing from you. Instead, your employer is likely withholding money from your paycheck for a range of taxes, including the federal income tax and the payroll tax, which you can see in the tax breakdown on your pay stub. Understanding the differences between these taxes, as well as how they affect the income tax return you file at the end of the year, helps you stay on top of your tax liabilities.
The Taxes Are Separate
FICA is separate from the federal income tax. The FICA tax is actually made up of two separate taxes: the Social Security tax and the Medicare tax. The FICA tax and federal income tax are similar in that the federal government collects both, but they differ in their purposes.
The federal income tax serves as general revenue for the federal government. At least in theory, Social Security tax revenues are earmarked for Social Security benefits paid out to seniors, surviving spouses and disabled individuals. The Medicare tax is used to pay for Medicare health care benefits.
Read more: What is FICA Tax Withholding?
Federal Income Tax Withholding Basics
Ever since World War II, taxpayers have been required to pay income tax as they earn throughout the year rather than in one lump sum when they file their taxes. Most taxpayers, however, don’t give a second thought to this requirement because they satisfy it through the income tax withholding from their paychecks.
The money withheld pays for federal income tax, sometimes abbreviated as FWT on your paycheck, is credited against the tax that you owe when you file your return at the end of the year. If you have too much withheld, you receive the excess back as a tax credit, but if you have too little withheld, you’ll have to pay the difference.
FICA Vs. Federal Income Tax
Federal income tax applies to all of your income, regardless of how you earned it. For example, you must include not only wages, bonuses and self-employment income on your income tax return, but also interest, dividends, capital gains and distributions from pretax retirement accounts like traditional IRAs and 401(k) plans. FICA taxes, on the other hand, only apply to your earned income, including wages, salaries, and bonuses. Unearned income, like interest, dividends, capital gains, pensions and annuities, is exempt from FICA taxes.
However, when calculating your federal income tax, you first get to claim a number of deductions on your tax return such as contributions to certain retirement plans, student loan interest and either the standard deduction or the sum of your itemized deductions, which include charitable contributions, state and local taxes and mortgage interest. You don’t get to claim these deductions when your employer calculates the FICA taxes due from your paycheck.
The two taxes also differ significantly when it comes to the tax rates imposed. The federal income tax is a progressive tax, which means that higher amounts of income are taxed at higher rates. In addition, your income tax rate depends on your tax-filing status. After the Tax Cuts and Jobs Act took effect for the 2018 tax year, individual income tax rates range from 10 percent up to 37 percent for the highest earner. But your long-term capital gains, which are profits from selling assets you’ve held for more than one year, are taxed at lower rates from zero to 20 percent, depending on your total income.
Social Security and Filing Status
Neither the Social Security tax nor the Medicare tax is affected by your filing status. The Medicare tax portion of the FICA tax is a flat tax of 2.9 percent for all earned income, split 1.45 percent for the employee and 1.45 percent for the employer. For example, whether your salary is $16,000 or $600,000, the same Medicare tax rate will apply to all of that income.
The Social Security tax rate is 12.4 percent, split equally at 6.2 percent for employees and 6.2 percent for employers. This tax is actually a regressive tax in that it only applies to a certain amount of earned income each year, known as the contribution and benefit base, which increases most years due to inflation. For example, in 2020, it increased by $4,800 to $137,700.
Once your earned income exceeds the contribution and benefit base, you don’t have to pay any additional Social Security tax. This means that for 2020, the maximum amount of Social Security tax withheld from your paycheck would be $8,537.40.
Tax Withholding for FICA Taxes
Typically, your FICA taxes are paid completely through withholdings from your paycheck because the exact amount is withheld as there aren’t subsequent deductions you have to factor in to calculate how much you owe. At the end of the year, your FICA tax withholding generally matches exactly what you owe, and you aren’t allowed to adjust your FICA tax withholding.
One exception is if you work multiple jobs and your total earned income exceeds the contribution and benefit base for the year because both employers are withholding Social Security tax. For example, say you work as an employee for two different companies with one paying you $91,000 for the year and the other paying $62,000. As far as each of your employers knows, your total earned income for the year is below the contribution and benefit base, so each employer will withhold the Social Security tax portion of FICA taxes on your entire salary.
However, that means you would have a total of $9,486 withheld from your paycheck for Social Security tax when the maximum for 2020 is $8,537.40. You’ll have paid in an extra $948.60. You can’t ask your employers to stop withholding Social Security tax by showing them your other pay stubs, but you can claim the excess withholding as a tax credit on your federal income tax return, which will either decrease the income tax you owe or boost your income tax refund.
Rules for Self Employment
Another exception is self-employment income. Technically speaking, self-employment income is subject to self-employment tax, rather than FICA tax, but the rules are the same except that when you’re self-employed, you must pay both the employer and the employee portions of the Social Security tax and the Medicare tax because you don’t have an employer with whom to split the taxes.
In addition, because you don’t have an employer to withhold the taxes, you must make estimated tax payments, typically quarterly, throughout the year for the amount that you owe rather than paying one lump sum at the end of the year.
Tax Withholding for Federal Income Taxes
The federal income tax withholding scheme is very different than for FICA taxes in large part due to the differences in how the taxes are calculated. Your employer calculates how much to withhold from each paycheck for federal income tax based on your income, filing status and the number of withholding allowances you claim on your taxes. Though your employer already knows how much you make, you need to submit a Form W-4 to your employer telling him what filing status to use.
Before 2020, the W-4 also used to report withholding allowances. Each withholding allowance you claim reduced the amount of your income that was subject to federal income tax withholding. Not anymore. From 2020, employees do not have the option to claim withholding allowances. Rather, you'll provide information such as your filing status, family income from all jobs, dependents and tax deductions you intend to claim, and you employer will do the necessary calculations.
Overwithholding and Underwithholding Federal Tax
If you complete Form W-4 correctly, you will often be close to what you actually owe in federal income tax, although it’s rare that your withholding will match your federal income tax liability exactly. So when you file your taxes, you either get a refund of the excess of what you paid in or have to write a check for the shortfall.
If you have too little withheld, you could also be on the hook for additional interest and tax penalties if you don’t meet one of the income tax withholding minimums. If you owe less than $1,000 in taxes, you’re off the hook for interest and penalties. You also avoid interest and penalties if your tax withholding equals at least 90 percent of your tax liability for the year.
For example, if you fill out your tax return and it turns out you owe $7,500 in taxes, you won’t have to add interest or penalties as long as your withholding is at least $6,750.
Penalties Based on AGI
The last safe harbor is based on your adjusted gross income and tax liability from the prior year. For taxpayers with an adjusted gross income of $150,000 or less (or $75,000 or less if you’re married filing separately), you won’t owe any interest or penalties for underwithholding as long as your current year’s tax withholding equals or exceeds your tax liability from the prior year.
For example, if you owed $11,000 in taxes last year, as long as your withholding for this year is at least $11,000, you’re safe. But, if you are what the IRS considers a “higher income” taxpayer, meaning your adjusted gross income for the prior year exceeds $150,000 (or $75,000 if you’re married filing separately), your current year withholding must equal at least 110 percent of your tax liability from the prior year. For example, if you owed $11,000 last year and your adjusted gross income was $155,000, your current year withholding would need to be at least $12,100 to meet the last safe harbor for avoiding interest and penalties.
Issues With Overwithholding
On the surface, there’s no penalty for overwithholding – the IRS isn’t going to penalize you for having too much money paid in through income tax withholding. However, the IRS also doesn’t pay you interest on the overwithholding from the time it was taken out of your paycheck until the time you get your tax refund. So, you’re essentially making an interest-free loan to the government for several months.
If that money simply sat in a low-interest account, it usually wouldn't have a big impact on your bottom line, but if you could have used that money to pay down high-interest debt sooner, it could be worth revisiting your federal income tax withholding.
- Social Security Administration: Contribution and Benefit Base
- IRS: Topic Number 306 - Penalty for Underpayment of Estimated Tax
- Fool: This Simple Tax Move Can Spare You Penalties
- Kiplinger: 10 Things Every Worker Needs to Know About the New W-4 Form for 2020
- Fool: What's the Maximum You Could Owe in Social Security Tax in 2020?
- Taxpayer Advocate Service, "Vol. 2, TAS Research and Related Studies: A Conceptual Analysis of Pay-As-You-Earn (PAYE) Withholding Systems as a Mechanism for Simplifying and Improving U.S. Tax Administration," Page 11. Accessed April 1, 2020.
- Internal Revenue Service. "Understanding Taxes -- Theme 2: Taxes in U.S. History." Accessed April 1, 2020.
- Internal Revenue Service. "Form W-4," Accessed April 1, 2020.
- Tax Foundation. "State Individual Income Tax Rates and Brackets," Pages 1–10. Accessed April 1, 2020.
- Social Security Administration. "Contribution And Benefit Base," Accessed April 1, 2020.
- U.S. Congress. "H.R. 748 - CARES Act." Accessed April 1, 2020.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."