Millions of seniors rely on Social Security to make ends meet during retirement. The program needs money to keep paying beneficiaries. It gets the bulk of its revenue from payroll taxes, but there's a wage cap that spares higher earners from paying Social Security tax on all of their income.
That wage cap changes from year to year. In 2020, the Social Security wage cap is $137,700. In 2021, however, that cap will rise to $142,800, meaning higher earners will part with more of their money to help fund Social Security.
How Social Security taxes on income work
All workers are required to pay a 12.4% Social Security tax on earnings up to the annual wage cap limit. If you work for an employer, you'll pay half that amount, or 6.2%, and your employer will pay the other half. If you're self-employed, you'll be on the hook for the entire 12.4% yourself.
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Here's what this means. Say you earn at least $142,800 in 2021. If you're self-employed, you'll owe $17,707.20 in Social Security taxes. If you're employed by someone else, you'll pay $8,853.60 in taxes, and your employer will pay the same amount. Any earnings above $142,800 won't be subject to taxes for Social Security purposes, but they will be subject to Medicare taxes, as there's no cap at play there.
Should higher earners pay more?
Social Security is facing a serious financial shortfall that, if left unaddressed, could force the program to cut benefits within the next decade and a half. One oft-proposed solution for pumping more money into Social Security is to raise the wage cap for payroll tax purposes, or even eliminate it, so that higher earners pay more into the program.
Right now, someone earning $142,800 in 2021 will pay the same amount of Social Security tax as a person earning $500,000. It's easy to argue that's not fair. On the other hand, Social Security pays a maximum monthly benefit. While higher earners don't pay taxes on all of their income, they also don't qualify for a higher benefit than that maximum.
Put another way, Social Security retirement benefits are calculated based on earnings, but a worker earning $500,000 in 2021 will only have $142,800 worth of wages factored into his or her benefits formula for that year; all excess income won't count toward a higher benefit. If the wage cap is lifted, Social Security theoretically might have to start paying a higher maximum benefit. That, in turn, could wipe out the cash infusion from taxing more earnings.
Of course, it's possible that lawmakers will decide to raise the wage cap without raising the maximum monthly benefit, but that's apt to result in backlash. There's no easy solution to the program's fiscal woes.
Prepare for your tax bill to go up
If you earn more than $137,700 a year, gear up to pay more Social Security taxes on your income next year. That may not be the news you want to hear, but knowing about it now will help you make plans to compensate. Maxing out a traditional 401(k) or IRA, for example, will help you lower your tax burden to offset the higher Social Security tax you'll need to pay.
