User:Fyre4ce/Payroll tax

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, also known as FICA (Federal Insurance Contributions Act) or FICA tax, is a tax in the United States against earned income. It is comprised of three components: Social Security tax on earned income up to the Social Security Wage Base ($147,000 in 2022), Medicare tax on all earned income, and the Additional Medicare Tax on earned income above $200,000 for single taxpayers or $250,000 for married couples (implemented by the Affordable Care Act (ACA)).

The Social Security tax and Medicare tax are shared between the employee and the employer; each pays half the tax, and the employer is required to withhold the employee's half of these two taxes from the employee's paychecks.

The Additional Medicare Tax is paid entirely by the employee, although employers are required to withhold the Additional Medicare Tax on all wages in excess of $200,000, without regard to the employee's filing status.

Description
Payroll taxes are summarized in the following table:

Details:
 * Payroll taxes are assessed against earned income (also called wages) only. Investment income (interest, dividends, etc.), real estate income reported on IRS Schedule E, and income from Partnerships or S Corporations reported on IRS Schedule K-1 (Form 1065) or IRS Schedule K-1 (Form 1120S), is not assessed payroll tax.
 * Contributions to Traditional 401(k)'s and IRAs are not payroll tax-deductible, only income tax-deductible.
 * Contributions to employer cafeteria plans, such as Health Savings Accounts (HSAs) and health insurance are payroll tax-deductible. The same type of contribution made outside those plans (e.g., directly to the HSA provider, or premiums for non-employer-provided health insurance) are not payroll tax-deductible.
 * Employers are required to withhold the employee's half of Social Security and Medicare tax from their paychecks.
 * Employers are also required to withhold the Additional Medicare Tax on all wages in excess of $200,000 per year, regardless of the employee's filing status.
 * Self-employed sole proprietors are required to pay both halves of the payroll tax, calculated on IRS Schedule SE (Form 1040). On the Schedule SE, net business profits are scaled down by a factor of 92.35%, so that the sole proprietorship gets to deduct the employer half of payroll taxes, similar to a corporation.
 * S Corporation owners are also required to pay both halves of the payroll tax, although they have the option to split compensation between wages and dividends, within certain restrictions, potentially reducing payroll tax (see below).
 * The Social Security Wage Base is adjusted annually by the Social Security Administration. Over the last several years, the figure has been increased by 3-4%/year.
 * The income thresholds for the Additional Medicare Tax ($200,000 for single filers and $250,000 for married joint filers) are not indexed for inflation.

Exemptions from paying payroll tax
Generally, workers are not allowed to "opt out" of paying payroll taxes, even if they are willing to forego future Social Security and Medicare benefits. However, certain types of jobs are exempt from payroll taxes, such as:


 * Children under age 18 employed by their parents through a sole proprietorship or partnership, but not a corporation
 * Certain international workers within the United States, such as nonresident alien employees of foreign governments, students, and employees of international organizations.
 * Full-time students employed by their university
 * Members of certain exempt religious organizations

Taxpayers are still required to pay Social Security tax even if they accumulate 35 years of earnings at or above the Social Security Wage Base.

Recovering excess payroll tax
For employees who work two or more jobs in a given year (either serially or concurrently), their employers are required to withhold Social Security tax from each paycheck. If the employee's total wages exceed the Social Security Wage Base (SSWB, $147,000 in 2022), then the employee will have excess Social Security tax withheld. Taxpayers are entitled to recover the excess Social Security tax. Claims for credit are entered onto IRS Form 1040 Schedule 3, on Line 11 on their federal income tax return, and will either be applied toward income tax owed, or returned as part of the taxpayer's tax refund.

If a single employer withholds excess Social Security in error, employees should seek a refund from their employer. If the employee's efforts are unsuccessful, they may request a refund on IRS Form 843.

While employees are entitled to a refund for excess Social Security tax, employers are generally not entitled to a refund for their half of Social Security tax payments if the employee worked another job and overpaid. This affects business owners, and can have a particularly large impact on taxpayers who own their own business through a Corporation, and also work a second job as an employee.

The Corporation is required to pay the employer side of the Social Security tax up to the SSWB, even if the owner knows that some of this tax is on wages in excess of the SSWB. This issue does not affect Sole Proprietors who work a second job as an employee, because IRS Schedule SE (Form 1040) corrects for Social Security tax paid from other employment.

Because the Medicare tax is assessed on all earned income, working for multiple employers does not create excess Medicare tax. However, the Additional Medicare Tax can create situations of under- or over-withholding. Employers are required to withhold Additional Medicare Tax on employee wages above $200,000, regardless of the employee's filing status. For example, a married employee who earns $250,000 of wages, and whose spouse does not work, will have $450 (($250,000 - $200,000) * 0.9%) of Additional Medicare Tax withheld, even though their actual Additional Medicare Tax due is $0.

Conversely, a married couple who each earn $200,000 of wages will owe $1,350 (($400,000 - $250,000) * 0.9%) of Additional Medicare Tax, even though none will be withheld. In both cases, the correction will be made on the federal tax return on IRS Form 8959, required to be filed with all federal tax returns subject to the Additional Medicare Tax.

As an investment
The Social Security portion of payroll tax has a similar character to an investment. Payments are made during working years, in exchange for an income stream once retired, and other benefits. In this section, the behavior of payroll tax as an investment is examined.

Option to pay payroll tax
For most taxpayers, there are no legal ways to avoid payroll taxes. Payroll taxes must be paid on all earned income, so this section will have only an academic interest. However, there are two common scenarios when taxpayers have some control over payroll tax:


 * Owners of S Corporations may decide to split their compensation partly as wages and partly as dividends from the business, reducing payroll taxes because they are not assessed on the dividends. This split is subject to the IRS requirement for "reasonable compensation."
 * Investors contributing to a Health Savings Account (HSA) may choose to pay through a payroll deduction, avoiding payroll tax, or directly to the HSA custodian.

Rate of return
The internal rate of return for Social Security benefits is calculated below for a variety of situations. Social Security benefits are calculated based on the sum of the taxpayer's top 35 years of earnings, adjusted for inflation and capped at the Social Security wage base each year. The sum, divided by 420 (35 years x 12 months) is the taxpayer's Average Indexed Monthly Earnings (AIME). The taxpayer's Primary Insurance Amount (PIA), their monthly retirement benefit when filing at Full Retirement Age (FRA), is calculated based on AIME using a progressive formula. AIME up to the first bend point, $1,024 in 2022, contributes 90% to PIA. AIME from this value up to the second bend point, $6,172 in 2022, contributes 32% to PIA. AIME beyond the second bend point contributes 15% to PIA. The three "brackets" of Social Security benefits are summarized in the following table:



The taxpayer's Social Security bracket is the primary factor affecting the rate of return. Other factors include:


 * Gender - Social Security benefits are unisex, but women live longer than men on average, and so expect to receive a larger benefit and therefore higher rate of return. When one spouse is receiving spousal benefits based on the other's earnings, the gap is reduced for opposite-sex couples and increased for same-sex couples.
 * Health - Likewise, individual taxpayers with longer life expectancy based on their health can expect a higher rate of return.
 * Income taxes - Half of payroll taxes are income tax-deductible, and future benefits may be taxable, so current and future tax rates affect rate of return.
 * Whether a spouse will be receiving benefits based on the taxpayer's earnings record. If so, the rate of return will be higher.
 * Whether one or both halves of payroll tax are paid by the taxpayer. The rate of return for paying only one half is higher. However, in practice, this is usually bad for a taxpayer making a decision, because the future benefit is being foregone for only half of the tax savings today.
 * Time - Payroll tax payments when older have the benefits return sooner, and so tend to have a higher magnitude of rate of return (ie. positive rates of return will be higher, negative rates will be more negative). In addition, a person's life expectancy naturally increases as they get older, because they have survived more potential causes of death. This effect improves the rate of return for older taxpayers, and can turn negative rates of return positive.

To the right are charts for four potential combinations of cases, of taxpayers paying either the employee half or both halves of payroll tax, and with or without the spouse receiving a 50% benefit :

Assumptions for these charts:
 * Both Social Security and Medicare taxes are included, because both have to be paid to get an AIME credit
 * Income tax rates at tax payment are 10%, 12%, and 24% respectively for 90%, 32%, and 15% brackets
 * Full Retirement Age (FRA) is 67 for both the taxpayer and spouse
 * Taxpayer and spouse are the same age, opposite-sex, and file for benefits at FRA, receiving 100% and 50% respectively of the taxpayer's PIA
 * Retirement benefits are untaxed for 90% and 32% brackets, but are taxed at the maximum 85% rate in the 24% income tax bracket (for a marginal tax rate of 20.4%) for the 15% bracket
 * Life expectancy is per the 2019 Social Security Administration actuarial life table, which is an average life expectancy for all Americans
 * Only retirement benefits are considered, not disability or survivor benefits

Payback rate
The payback rate, defined here as the percentage of a payroll tax payment expected to be paid back on an inflation-adjusted basis, is shown below. Although not as good a metric of investment performance as rate of return, because it ignores the time value of money, it nonetheless gives an idea of whether the tax payments have more of a character of an investment or an ordinary tax.

Situations when payroll tax provides no return on investment
In the following situations, paying additional Social Security tax provides no direct benefit to the taxpayer, and the payments can be considered an ordinary tax, to be avoided where possible:


 * The taxpayer will not accumulate 40 work credits (equivalent to 10 years of earnings) necessary to qualify for Social Security retirement benefits
 * The taxpayer has worked (or will work) more than 35 years, and the current year will not be one of the highest 35 years of earnings
 * The taxpayer's personal Social Security benefit will be smaller than 50% of their spouse's benefit

In addition, all payroll tax payments above the Social Security wage base, comprised of only Medicare taxes, also provide no direct benefit to the taxpayer.

Comparison to traditional investments
Social Security is most closely analogous to an annuity. Compared to traditional investments, Social Security has some important advantages and disadvantages. Separate from the rate of return, advantages include:


 * Benefits are automatically indexed to inflation
 * Benefits grow tax-deferred
 * Benefits are asset-protected from most creditors
 * Benefits are protected from being misspent by the taxpayer, which is the main reason Social Security was created in the first place
 * Benefits are tax-advantaged - tax-free to many retirees, only up to 85% of benefits are taxable federally, and most states do not tax benefits
 * Benefits have an insurance value, in that they continue as long as the recipient is alive. This provides utility beyond the expected rate of return, in that it provides additional funding for a long retirement that stretches other savings. A taxpayer can buy a SPIA when they retire, but SPIA's tend to have lower rates of return than Social Security, and importantly are not indexed to inflation, so are not nearly as good insurance against high longevity.

Disadvantages include:


 * Benefits are illiquid and can't be accessed before filing, or in lump-sum form (without separately taking out a loan and using the benefits to make payments)
 * Benefits are lost at death and can't be passed to heirs, except for spousal benefits which continue until the spouse's death, and survivor benefits for taxpayers who die before retirement age

The risks of Social Security are different than traditional investments. Compared to bonds, there is no interest rate risk, and the credit risk is very low, comparable to other government-backed investments like treasury bonds or TIPS. Compared to stocks, there is no price volatility, nor business or market risk. However, there is a significant legislative risk that the program could be changed in the decades between when a taxpayer pays payroll tax and is scheduled to receive benefits. This risk reduces dramatically, although is not completely eliminated, once a taxpayer files for and begins to receive benefits.

Recommendations
Taxpayers who expect to be in the 90% bracket at retirement should not avoid payroll tax, which is probably the best investment that can be made.

Taxpayers who expect to be in the 32% bracket at retirement can expect a modest return. HSA contributions should be made directly to the custodian so as not to avoid the employee half of payroll tax, except for young males and/or taxpayers who would otherwise be able to invest the taxes in a retirement account such as an IRA or 401k. However, older (age 55+) taxpayers should not avoid payroll tax in any case.

Taxpayers who expect to be in the 15% bracket at retirement should expect zero or negative real returns from payroll taxes, and should avoid paying them where possible.