Most Americans are quite familiar with federal and state income taxes, but payroll taxes aren't understood quite as well.
Payroll taxes are types of tax that are applied to earned income, meaning wages, salaries, bonuses, and income from a business you actively participate in. There are two components to the payroll tax in the United States -- Social Security and Medicare. Each one has different rates, income limitations, and other details to know. So, let's look at them one at a time.
Social Security tax
The first component of the U.S. payroll tax is known as OASDI (Old Age, Survivors, and Disability Insurance) tax, but it is more commonly referred to as Social Security tax.
Social Security tax is assessed at a rate of 6.2% of taxable payroll on both employees and their employers. Each year, the Social Security tax only applies to a certain amount of earned income. In 2021, the upper limit -- commonly known as the Social Security wage base -- is $142,800. (Note: This is the only income threshold in this article that is adjusted for inflation each year.)
It's important to note that Social Security tax only applies to earned income. In other words, if some or all of your income comes from passive sources, such as dividends, interest, pensions, or income from a business you don't have an active role in, it won't be subject to Social Security tax.
Since Social Security tax can only be applied to the first $142,800 in earned income and the rate is 6.2%, the maximum Social Security tax an employee will have to pay in 2021 is $8,853.60. Social Security tax revenue is directed into the Social Security trust fund, along with an equal contribution from the employer, to fund future benefits from the program.
The second component of the payroll tax is Medicare, which is taxed at a rate of 1.45% each for the employee and employer. Unlike the Social Security tax, there is no upper income limit to the Medicare tax. Even if your earned income is in the millions, you'll pay Medicare tax on all of it.
In fact, there's an additional 0.9% Medicare tax paid by individuals with earned income in excess of $200,000 and joint filers with earned income greater than $250,000 that only applies to income over the threshold.
For example, if you file your tax returns as a single filer and have $300,000 of wage income in 2021, you'll pay 1.45% Medicare tax on the first $200,000 and 2.35% (1.45% plus 0.9%) on the other $100,000.
It's important to realize that self-employed individuals pay both the employer and employee sides of the payroll tax, since they technically perform both roles. This means they pay a Social Security tax rate of 12.4% on earned income up to $142,800 in 2021, Medicare tax of 2.9% on all income, and the 0.9% additional Medicare tax on income in excess of $200,000 (or $250,000 if filing jointly). In all, here's how the self-employment tax breaks down for a single individual who gets all of their income from self-employment in 2021:
- 3% tax on the first $142,800 in self-employment income.
- 9% tax on income from $142,800 to $200,000.
- 8% tax on income in excess of $200,000.
Of course, for self-employed individuals who file joint returns, the threshold for the additional Medicare tax is $250,000.
The Foolish bottom line
Nobody likes paying taxes, but the payroll taxes in the U.S. fund some pretty important programs. And as a final thought, it's entirely possible that one (or both) parts of the payroll tax could increase in the not-too-distant future, as both Social Security and Medicare face long-term funding shortfalls.