Whether you realize it or not, Social Security plays a key role in keeping millions of Americans out of poverty in the United States. The Center on Budget and Policy Priorities finds that of the nearly 63 million people currently receiving a benefit, more than 22 million are kept above the federal poverty level as a result of their guaranteed monthly payout.
Although Social Security has three sources of funding, its workhorse is the 12.4% payroll tax on earned income (i.e., wages that are paid). In 2017, the payroll tax was responsible for more than 87% of the $996.6 billion collected by the program.
The way Social Security's payroll tax works is pretty straightforward. In 2019, all earned income up to $132,900 is subject to the 12.4% tax. The only question is: Who winds up paying this tax? If you're self-employed, you're on the line for the full 12.4% up to $132,900. However, if you're employed by someone else, you and your employer will split this responsibility down the middle (6.2% each).
Surprise! These seven income sources are exempt from the payroll tax
But what you may not realize is that a lot of income can't be touched by Social Security's payroll tax -- a touchy subject, mind you, with an estimated $13.2 trillion cash shortfall awaiting Social Security between 2034 and 2092. Here are seven income sources that may be subject to federal and/or state income taxation but are exempted from Social Security's payroll tax.
1. Dividend income
Dividend stocks are great for a variety of reasons. They tend to outperform their non-dividend-paying peers over the long run, usually have time-tested business models, can help hedge against inevitable stock market downturns, and can supercharge wealth creation via reinvestment. But another under-the-radar benefit is that dividend income isn't subject to Social Security's payroll tax. That's great news with a record amount of dividends being paid out in 2018.
2. Bond income
Few things are as steady as the interest income investors can earn from a bond. One of the prime benefits of bond income is that it's exempted from the payroll tax. Depending on the type of bond, it may also be exempted from federal and/or state tax. For instance, municipal bonds purchased within the state you reside may pay interest that's completely exempt from any form of taxation.
3. Rental income
In most instances, rental income won't be subject to Social Security's payroll tax, either. The one exception in the past has been if you're considered a real estate professional. In order to meet that title, you'd need to perform more than 750 hours of services during the tax year in real property trades or businesses (that's close to five months of work, assuming an eight-hour day, five-day week), and have more than half the personal services you perform be in real property trades or businesses. Assuming you don't meet the definition of a real estate professional, your rental income is considered exempt from the payroll tax.
4. Capital gains
As an investor, you're also liable to generate unrealized gains on your investments. When you finally sell and lock in those profits, this becomes a capital gain. Although capital gains may be subject to varying levels of federal income tax, depending upon whether they're considered short term (held for 365 days or less) or long term (held for 366-plus days), capital gains aren't subject to the payroll tax. As you've probably noticed by now, investment income is your ticket to exemption.
5. CD interest income
Purchasing a CD (certificate of deposit) from a bank and collecting interest on that money is one of the safest, but often lower-yield, ways to make money. There's a good chance you'll pay federal and/or state tax on your CD interest income, depending on your tax bracket, but you wouldn't be subject to the payroll tax based on your CD interest income.
6. Student income
For you students out there, a way to make money that'll be exempted from Social Security's payroll tax is to get a job at your university while pursuing a higher education. Although you'll have to show that you're enrolled at a qualified institution and attending class, your student income earnings won't be hit by the payroll tax.
7. Exempt wage income
Last, but not least, even some wage income can escape the clutches of the payroll tax. In 2019, earned income of between $0.01 and $132,900 is subject to the 12.4% tax. However, wage income above $132,900 is exempt. This taxable earnings cap rises in step with the National Average Wage Index each year, but in 2016, according to the Social Security Administration, an estimated $1.2 trillion in earnings escaped the payroll tax.
In other words, investors, students, and the rich each have a path to escape Social Security's payroll tax to some degree.