If you've ever received a paycheck from your employer, you've probably felt a sense of accomplishment and disappointment all at once. The accomplishment comes in the form of the cash that'll be flowing into your bank account, whereas the disappointment comes from the realization that you may owe quite a bit of tax on the wages you've earned.
Understanding the taxation of wages
Most of us are quite aware of the need to pay federal tax on our income. Even though a majority of Americans receive a federal tax refund each year, we expect a certain percentage of our wages to be withheld each pay period because of federal income taxes. The same can be said for residents in 43 states which also have a state income tax.
However, we as workers also have control over the percentage of federal income taxes taken out of our paychecks via Form W-4. Employees have the ability to change their federal (and state) tax withholding on an as-needed basis. Adjusting your W-4 can come in particularly handy if you expect a big federal refund at the end of the year. Allowing the federal government to hang onto your money on an interest-free basis simply isn't smart. Instead, you can lower your tax withholding or claim a federal tax exemption and boost the size of your paychecks toward the end of the year.
But, what might stand out on your paycheck and have you scratching your head is a tax column labeled "FICA." You might be wondering what this FICA tax is and why you don't have the same luxuries to control how it taken out of your wages as you do with federal and state income taxes. Let's take a closer look.
What is the FICA tax?
FICA stands for the Federal Insurance Contribution Act tax, which was passed in 1935 as part of the Social Security Act -- the piece of legislation that created the program responsible for paying monthly benefits to more than 41 million current retirees, and more than 60 million beneficiaries in total each month.
FICA taxes help fund two critical federal programs that are predominantly designed to protect the financial and physical well-being of our nation's seniors.
First, FICA taxes remove a percentage of your wages to help fund Social Security (which may show up on your paycheck as FICA OASDI, representing the Old-Age, Survivors, and Disability Insurance Trust). The official FICA tax on wages for Social Security works out to 12.4%, but thankfully not too many workers are exposed to the full brunt of this tax. If you're employed by someone else, the responsibility of the 12.4% payroll tax is split down the middle between you and employer, 6.2% each. If, however, you're self-employed, you'll owe the full 12.4% tax.
But, Social Security's payroll tax only impacts a specified income range which changes most years based on wage growth. In 2017, all wages between $0.01 and $127,200 are subject to the payroll tax. Any wages earned above and beyond $127,200 are free and clear of the payroll tax.
Second, the FICA tax helps fund Medicare, of which roughly five out of six eligible members are seniors aged 65 and up. The Medicare tax portion of FICA works out to 2.9%, but just as we saw with the payroll tax, the responsibility of the Medicare tax is split down the middle between you and your employer, 1.45% each. Similarly, the self-employed owe all 2.9%. However, unlike the Social Security payroll tax, the Medicare tax applies to all earned income, not just what's earned up to $127,200.
There's also a third component to the FICA tax that's tied into Medicare for a small percentage of the population. Passed along with the Affordable Care Act, there's a 0.9% Medicare surcharge tax added to taxpayers who earn more than $200,000 in income. This 0.9% tax remains entirely on the employee side of the equation, meaning your employer owes 1.45% on the entirety of your wages while you would owe 1.45% on wages up to $200,000, and 2.35% on any wages above and beyond this amount.
In total, the FICA tax rate works out to 15.3%, with most Americans responsible for 7.65% if they're not self-employed. Here's a handy bullet point that summarizes the above:
- Social Security tax responsibility: 6.2% each for you and employer up to $127,200 in wages.
- Medicare tax responsibility: 1.45% each for you and your employer (with no income limit).
- Medicare surcharge tax: 0.9% just for the employee on wages over $200,000.
Do I have to pay FICA taxes?
One of the more interesting aspects about FICA taxes is that unlike federal or state income taxes, employers are required by law to withhold a percentage of an employees' wages for FICA. The percentage withheld? You guessed it... 7.65%. Employers also have a responsibility to pay 7.65% toward FICA as well.
According to data from the Social Security Administration, payroll taxes accounted for a hair over 86% of Social Security's revenue in 2015. Meanwhile, Medicare relied on FICA taxes in 2014 for 38% of its total program revenue. However, the Hospital Insurance Trust, which covers Part A (also known as hospital insurance), relied on FICA taxes to generate 87% of its annual revenue in 2014. In other words, if FICA tax withholding wasn't mandatory, Social Security and Medicare Part A could struggle to find adequate annual funding.
Paying taxes may not be much fun for the average American, but those FICA taxes are ensuring that you and future generations of retired workers will have income and adequate healthcare during your golden years.