When you see your pay from your employer directly deposited into your account or receive a paper check, the amount you receive is less than you’ve earned because of tax withholding. In addition to state and federal income taxes, you’ll also see payroll tax taken out. Payroll taxes, official known as FICA taxes, are a combination of several taxes that apply only to earned income. Knowing how these taxes work help you budget for what your take-home pay will actually be after tax withholding so you can plan ahead for your spending.
FICA tax withholding refers to the money your employer takes out of your paycheck to cover the Social Security and Medicare taxes imposed on earned income by the federal government.
What Is FICA?
FICA, or the Federal Insurance Contributions Act, includes the Social Security tax, the Medicare tax and the additional Medicare tax. These taxes apply only to your earned income, such as your wages, salaries, overtime and bonuses. The tax doesn’t apply to any unearned income such as interest, dividends and capital gains. You also don’t pay the FICA tax on distributions from pensions, annuities, Social Security benefits and qualified retirement accounts, such as IRAs and 401(k) plans. Generally, FICA taxes are withheld precisely from your paycheck so you don’t need to make any adjustments to them on your tax returns.
Income Exempt From FICA
Certain earned income is exempted from FICA. One notable exception is for students who also work for their school. As long as the primary relationship between the student and the school is for education, the student’s earnings aren’t subject to FICA taxes. This exception only applies as long as the relationship is primarily education-based. For example, say that while you’re a full-time student, you work part-time for the athletic training staff at the school. Because your primary relationship with the school is as a student, your wages aren’t subject to FICA taxes. But, if you graduate and are hired to work in the school’s athletic training department full-time, your wages are subject to FICA taxes, even if you continue to take a class or two at the school.
In addition, most fringe benefits are subject to FICA taxes. For example, if your compensation package includes the use of a car or travel perks that have a fair market value of $5,000 per year, you have to pay FICA taxes on that $5,000 even if your employer pays those costs directly to the provider on your behalf.
However, if your employer pays for medical insurance on your behalf, those payments aren’t subject to FICA taxes. For example, if your employer pays $300 per month directly to the insurance company for your medical premiums, you don’t have to pay FICA taxes on that $300. But, if you pay insurance premiums from your paycheck, those premiums are still subject to FICA taxes even if they’re excluded from your taxable income. For example, say your total monthly insurance premium is $500. If your employer pays $300 on your behalf and you pay the remaining $200 through a paycheck deduction, you only pay FICA taxes on the $200, not the full $500.
Similarly, if your employer makes contributions to a retirement plan on your behalf, such as a 401(k) plan, you don’t have to pay FICA taxes on those contributions. Contributions that you make are subject to FICA taxes, however. For example, say that every pay period, you contribute $200 of your paycheck to your 401(k) plan and your employer makes a matching contribution of $200 on your behalf. Even though you’re essentially earning $400, the $200 your employer contributes isn’t subject to FICA taxes.
Understanding the Social Security Tax
The Social Security tax totals 12.4 percent, divided equally so that 6.2 percent is withheld from your paycheck and your employer pays an additional 6.2 percent on your behalf. The tax is used to pay for Social Security benefits to seniors, surviving spouses and dependents, and disabled individuals. The tax applies to your earned income starting from the first dollar, but it is capped so that once your earned income exceeds a certain dollar amount during the year, you don’t pay it anymore. As a result, each year there is a maximum amount you have to pay in Social Security taxes.
The cap on income subject to the Social Security tax is known as the contribution and benefit base, and it adjusts annually for inflation. For 2018, the contribution and benefit base is set at $128,400, which means that you and your employer won’t pay more than $15,921.60 total, or $7,960.80 each, in Social Security taxes for the year.
If you earn more than the Social Security contribution and benefit base and only work one job, your employer will simply stop withholding Social Security taxes from your paycheck once your income exceeds the limit. For example, if your salary is $143,400, your employer will withhold Social Security taxes from the first $128,400 of your salary, and the last $15,000 won’t be subject to Social Security taxes.
But, when you work multiple jobs, things can get a little more complicated. Your multiple employers don’t share information with each other about your wages, so they won’t know when your total earned income exceeds the contribution and benefit base across all of your jobs. Therefore, each employer must withhold Social Security taxes on all your income until the earned income paid by each employer exceeds the contribution and benefit base. But, you’ll receive the excess back on your income tax return.
For example, say that your primary job pays you a $140,000 salary and you do a little work for another company that pays you $15,000. Your main job will withhold Social Security taxes from the first $128,400 of your salary and stop because you’ve reached the contribution and benefit base. But, your second job will also withhold Social Security taxes on the full $15,000, resulting in an extra $930 withheld for Social Security taxes. When you file your tax return, you receive a tax credit equal to $930 so you’ll get the money back or at least have it offset your other tax liabilities.
Understanding the Medicare Tax
The Medicare tax, also known as Hospital Insurance or HI, is used to pay for the Medicare benefits for seniors. The tax is a 2.9 percent total tax that is split 1.45 percent by the employee and 1.45 percent by the employer. However, unlike the Social Security tax, the Medicare tax applies to every dollar of earned income throughout the year from the first dollar to the last dollar. For example, if your salary is $77,000, you’ll see $1,116.50 withheld from your paychecks over the course of the year, and your employer will pay an additional $1,116.50 in Medicare taxes on your behalf.
Additional Medicare Tax
Most taxpayers won’t have to worry about the additional Medicare tax, which is an additional 0.9 percent tax imposed on earned income and paid entirely by the employee, because it only applies to high-income taxpayers. Unlike the Social Security tax and the standard Medicare tax, the additional Medicare tax doesn’t apply to your earned income until you reach the income threshold for your filing status. For singles and heads of household, the tax applies to earned income in excess of $200,000. For married couples who file a joint return, it applies to all earned income of the couple in excess of $250,000. For married couples who file separately, each spouse pays the additional Medicare tax on any income earned by that spouse in excess of $125,000.
The additional Medicare tax also differs from the Social Security tax and the standard Medicare tax because your withholding might or might not reflect how much you actually owe. For all taxpayers, employers are required to start withholding the additional Medicare tax when the wages paid to that taxpayer exceed $200,000, regardless of the taxpayer’s filing status. This could lead to too much or too little being withheld, depending on each taxpayer’s situation, which means you’ll either have to pay the difference or have the excess refunded at tax time.
For example, say you’re married but you’re going to file a separate return from your spouse. You are required to pay the additional Medicare tax when you’re earned income for the year exceeds $125,000. If your salary is $160,000, that means you’ll owe the tax on the last $35,000 for a total of $315. But, because your employer didn’t pay you more than $200,000 during the year, you won’t have any money withheld from your paychecks and will have to pay the $315 at tax time.
On the other hand, say you’re married and will file jointly with your spouse. You work full-time and earn a $222,000 salary, while your spouse only works part-time and brings home $25,000. Your combined earned income for the year is $247,000, which is below the threshold for a married couple filing jointly to owe the additional Medicare tax. However, because your salary exceeded $200,000, your employer withheld the 0.9 percent additional Medicare tax from your paycheck on the last $22,000 for a total of $198. But, fear not, you will have that $198 credited to you on your tax return so you will get that money back.
Navigating Self-Employment Income
If you’re self-employed, you might be thinking that you’re getting off easy because you don’t have an employer to withhold FICA taxes from your paychecks. While you’re right that you don’t have an employer to withhold taxes, you’re missing the mark overall because your net self-employment income is subject to self-employment taxes. It wasn’t always this way as when FICA taxes were first introduced in 1937, self-employment earnings weren’t subject to a similar tax. The self-employment tax was introduced in 1951, but it wasn’t until 1984 that self-employment taxes were set equal to the combined employer and employee portions of FICA taxes.
Today, the self-employment tax, like the FICA tax, is composed of the Social Security tax and Medicare tax. However, because you won’t have an employer to split the tax with, self-employed taxpayers pay the entire amount themselves, which is 12.4 percent for the Social Security tax and 2.9 percent for the Medicare tax.
The tax code does contain a few provisions to ensure equal payroll and income tax consequences for both employees and self-employed individuals. First, the self-employment tax is calculated based on 92.35 percent of net self-employment income because FICA taxes are calculated on the employee’s income which doesn’t include the FICA taxes the employer pays on the employee’s behalf. Second, when self-employed taxpayers file their income tax return, they are allowed to claim an income tax deduction equal to what would be the employer portion of the self-employment tax. You can still claim this deduction even if you’re not itemizing because it’s classified as an adjustment to income.
- Social Security Administration: Social Security and Medicare Tax Rates
- Social Security Administration: Contribution and Benefit Base
- IRS: Retirement Plan FAQs Regarding Contributions - Are Retirement Plan Contributions Subject to Withholding for FICA, Medicare or Federal Income Tax?
- IRS: Student Exception to FICA Tax
- IRS: What is the Additional Medicare Tax?
- IRS: Topic Number: 751 - Social Security and Medicare Withholding Rates
- IRS: Self-Employment Tax (Social Security and Medicare Taxes)
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."