Your Guide to Social Security Taxes

Social Security works on a pretty simple premise: Pay taxes on your wages during your career, and as a senior you'll get to collect Social Security benefits, either when you retire or when you're somehow left unable to earn a living prematurely. Over the years, that framework has worked to pay trillions of dollars to beneficiaries, providing generations of workers with vital financial support in their retired years.

Even though Social Security is critically important, many people don't understand the taxes they pay to fund the system. This guide will take a closer look at Social Security taxes and their inner workings -- and in the process help you plan to maximize your benefits while paying as little in employment or self-employment taxes as possible.

Image source: Getty Images.

How do Social Security taxes work?

The bulk of the money that Social Security pays out in annual benefits to retirees and disabled individuals comes from the payroll taxes that workers and their employers pay into the system. On some paychecks, Social Security taxes are specifically broken out, while on others, Social Security and Medicare taxes are combined into one line, typically called FICA because of the Federal Insurance Contributions Act that authorizes their collection by the federal government.

In the early part of its history, Social Security was purely a "pay as you go" program, meaning it only collected enough tax revenue to fund its current payout needs. As the chart below indicates, Social Security tax rates in the early years of the program amounted to just 1% of wages. As more retirees joined the payment rolls, however, rates increased dramatically, hitting 3% by 1960 and topping the 5% mark by the late 1970s.

Social Security reforms in the 1980s led to further tax rate increases. The nature of Social Security funding changed with the advent of Social Security Trust Funds that would not only hold the money necessary to make immediate payouts to recipients, but also accumulate and invest assets needed to meet future obligations. In order to ensure that enough money would go into the trust funds to meet their long-term financial needs, lawmakers also boosted the Social Security tax rate, sending it above the 6% mark by the late 1980s. Remarkably, the same tax rate has been in effect since 1990, as the 1980s amendments to Social Security have thus far been adequate to fund the system. Moreover, politicians have been reluctant to deal with Social Security's long-term funding problems -- another reason the tax rate has been left unchanged for more than a quarter-century.

Data source: Social Security Administration.

What's the Social Security tax rate right now?

Under current law, your employer will withhold 6.2% of your eligible earnings -- sometimes referred to in a somewhat confusing way as "Social Security income" -- in Social Security tax under FICA. Your employer will also pay the same amount out of its own pocket, bringing the total tax paid on your behalf to 12.4% of your wages. Those who have self-employment income typically have to pay the entire 12.4% on their own, as they're both employee and employer for Social Security purposes.

If you pay a single unified amount under FICA for both Social Security and Medicare, then you'll probably notice that it adds up to 7.65%. That includes both the 6.2% that goes to Social Security and the 1.45% tax that helps to fund the Medicare program.

For high-income earners, there's an additional wrinkle to keep in mind: There's a limit on how much of your earned income will be subject to Social Security taxation. That amount, known as the Social Security wage base, varies from year to year based on increases in overall wages. The wage base for 2018 is $128,400. Your employer will withhold full Social Security taxes on your wages until they exceed that amount, and any earnings beyond that will be free from the Social Security tax.

When you reach the limit, you'll have paid the maximum Social Security tax of $128,400 times 6.2%, or $7,960.80. However, you'll still potentially have some withholding for employment taxes taken out of your pay, because even after you've met the maximum requirement for the Social Security portion of your FICA taxes, you'll still owe the remaining 1.45% amount toward your Medicare tax obligations. Medicare taxes are not limited to any wage base, so you'll potentially see an increasing tax liability as your earnings keep going up.

Image source: Getty Images.

Criticism of Social Security taxes

Because of the wage base limit on the amount of tax imposed, Social Security taxes are an example of a regressive tax, which means those who have less income pay a higher tax rate than those who have higher levels of income. No matter how much you earn, the $7,960.80 amount above is the most you'll pay in 2018. So most people end up paying 6.2% in Social Security tax, but high earners may pay a much lower rate. For instance, if you make $1 million, then the maximum annual Social Security tax represents an effective rate of less than 0.8%.

Tax policy advocates typically don't like regressive taxes, instead supporting taxes that impose lower tax rates on lower-income Americans and raise those rates along with taxpayers' income. That's a popular argument in favor of lifting the Social Security wage base limit or eliminating it entirely. Proponents argue that this would generate much more funding for Social Security and help the program remain financially viable well into the future.

There's also some precedent for changing the way that similar employment taxes are imposed. For a long time, the Medicare taxes that the federal government collected through payroll withholding were also subject to a wage base limit. Initially, that wage base was set to be the same as Social Security's, and that held true through 1990. From 1991 to 1993, Medicare's wage bases were set much higher than Social Security's wage base, meaning that high-income earners had to pay more in Medicare tax. Starting in 1994, the Medicare wage base limit went away entirely, leaving a potentially unlimited amount of income subject to Medicare tax for ultra-high-income workers.

Reasons why a regressive Social Security tax makes sense

There are a couple of good counterarguments for the regressive nature of Social Security taxes. First, the way Social Security benefits are calculated also takes into account the maximum amount of taxes collected under the wage base limits. For instance, for someone who retires at full retirement age in 2018, the maximum Social Security benefit will be $2,788 per month. That's the amount payable to retirees who have earned the maximum wage base or more for at least 35 years.

Under the current Social Security benefit formula, if you took away the wage base limit, there would be no theoretical limit to the amount of Social Security benefits you could earn. For instance, for someone retiring in 2018, the way Social Security benefits are calculated follows a simple three-step process:

• Take the recipient's work history and adjust each year's earnings to account for inflation.
• Find the average indexed monthly earnings (AIME) for the 35 top-earning years of the worker's career.
• Add up 90% of the first $895 in AIME, 32% of the amount between $895 and $5,397 in AIME, and 15% of the amount exceeding $5,397 in AIME. The sum is their base monthly benefit.

Extending the wage base could push the monthly payments of ultra-high-income beneficiaries much higher. For instance, someone who consistently earned the inflation-indexed equivalent of $1 million per year throughout their career would have an AIME of more than $83,000, and if you run the numbers through the above formula, the resulting monthly Social Security check for a million-dollar earner would jump by nearly $11,000 per month.

That's a notion that isn't likely to be popular among lawmakers, so the likely alternative would be to adjust the benefit calculation formula to make it less lucrative for high-income retirees. Yet even that's not a perfect solution, because if wealthy taxpayers have to pay bigger tax bills while getting less in return from the program, it could lead to political opposition that could threaten the entire Social Security system.

Indeed, the regressive nature of the Social Security tax is balanced by the fact that retirement benefits replace a very high percentage of low earners' pre-retirement income while replacing only a small portion of high-income recipients' previous earnings. In other words, since lower-income workers get proportionately more from the system, it arguably makes sense that they bear the brunt of a regressive tax bill.

Tax credits that effectively return Social Security tax payments to taxpayers

In addition to the arguments above, another reason why Social Security taxes aren't totally unfair is that the low-income taxpayers who are arguably hurt most by the taxation are often entitled to offsetting tax credits elsewhere. The biggest example is the earned income tax credit, which is a substantial credit primarily aimed at low- and middle-income families.

Under the earned income tax credit, families are entitled to receive credits that vary depending on the size of their families and their filing status. Married couples who file jointly can earn as much as $54,884 in 2018 and still receive a credit if they have three or more eligible children. The income limits get smaller as family size shrinks. The maximum credit amounts also vary, ranging from $6,431 for those with three or more children down to $3,461 for those with one child and $519 for those with no children.

What's interesting about the earned income tax credit for those with no children is that it's exactly equal to the 7.65% total FICA tax due -- the 6.2% Social Security tax plus the 1.45% Medicare tax -- until the credit reaches its maximum. In other words, lawmakers specifically intended for the earned income tax credit to offset the Social Security and Medicare employment taxes for low-income earners. It seems they recognized that the Social Security tax is regressive and wanted to remedy that for Americans who need financial support the most.

Could Social Security taxes go up?

For those who are looking for ways to increase Social Security's revenue, an alternative to raising the wage base limit would be to increase the Social Security tax rate. With the 6.2% tax having been in place since 1990, some policymakers would argue that enough time has gone by to consider a further increase.

Each year, the Social Security Trustees Report analyzes what it would take to solve the program's long-term financial issues. Based on current Social Security tax rates and benefit estimates, the program is likely to exhaust the money in its trust funds by the mid-2030s, and that would likely result in a benefit cut of between 20% and 25%.

To avoid that, an increase in payroll taxes would be one option. According to calculations in the Social Security Trustees Report, if lawmakers were to implement a Social Security tax increase immediately, then it would take a total tax rate increase of 2.78 percentage points to keep Social Security solvent through the 75-year projection period that the trustees examine each year. That would bring the total payroll tax for Social Security to 15.18%. That means employees would pay 7.59% out of their paychecks, while employers would also see their rate rise by 1.39 percentage points to 7.59%. Assuming the current Medicare tax portion of FICA were left unchanged, total employment taxes paid by employees would rise to 9.04%. Self-employed individuals would end up paying both halves of the Social Security tax, with 15.18% going to Social Security and total self-employment taxes rising to 18.08%.

That may sound like a costly solution, but the cost of stalling would be even greater. The Social Security Trustees also looked at the much more likely scenario that lawmakers will wait until the Social Security Trust Funds have run out of money before taking action to restore revenue by raising payroll tax rates. In that event, it would take a massive increase of 3.87 percentage points overall to fix the problem, assuming the increase took effect in 2034, when the trust funds are currently projected to run dry. That would work out to a 1.94 percentage point hike to 8.135% for employees and a matching 8.135% rate for employers, while self-employed individuals would pay 16.27% for the Social Security tax portion alone. Adding Medicare taxes into the mix, typical employees would face a 9.575% total FICA tax, while the self-employed would pay a whopping 19.17%.

Keep your eye on Social Security taxes

Social Security taxation is an area that's very much in flux among policy advocates and lawmakers in Washington. With so many financial challenges on the horizon for the program, the question of where Social Security will get the funding it needs to cover the retirement and family benefits of the massive and currently retiring baby boomer generation remains largely unanswered.

In the end, for Social Security to keep paying the benefits it owes, the program has only a couple of choices. Either it can sustain the benefit levels that it's currently scheduled to pay and collect more tax revenue through increases in the Social Security tax, or it can maintain its current levels of taxation and instead decrease the amount of benefits it pays. Neither answer is all that attractive politically, as neither higher taxes nor lower benefits sound great to voters. Yet the federal government will have to face this problem within the next decade and a half if it wants to prevent a budding Social Security crisis from inflicting its full brunt on retirees and other recipients in the mid-2030s.