Payroll tax

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Payroll tax, also known as FICA (Federal Insurance Contributions Act)[1] 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 ($132,900 in 2019), 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.[2]

Description

Payroll taxes are summarized in the following table:

Payroll Tax Tax Rate Income Limits[3]
Employee half of Social Security tax 6.2% Up to Social Security Wage Base ($132,900 as of 2019) for each individual
Employer half of Social Security tax 6.2% Up to Social Security Wage Base ($132,900 as of 2019) for each individual
Employee half of Medicare tax 1.45% All earned income
Employer half of Medicare tax 1.45% All earned income
Additional Medicare Tax 0.9% Earned income above $200,000 for single filers, or $250,000 for married joint filers

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[4] 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 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[5]
  • Certain international workers within the United States, such as nonresident alien employees of foreign governments, students, and employees of international organizations.[6]
  • Full-time students employed by their university
  • Members of certain exempt religious organizations[7]

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, $132,900 in 2019), 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 Schedule 5 (Form 1040), on Line 72 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.[8] 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.

Avoiding payroll tax

For most taxpayers, there are no legal ways to avoid payroll taxes. However, owners of S Corporations may decide to split their compensation partly as wages and partly as dividends from the business,[9] reducing payroll taxes because they are not assessed on the dividends. This split is subject to the IRS requirement for "reasonable compensation."[10]

Even if a business owner is legally entitled to pay lower payroll taxes, there may be compelling reasons not to, such as the cost of becoming and remaining incorporated (compared to operating as a Sole Proprietor), lower employer contributions to a Solo 401(k), and a potentially desirable rate of return on Social Security tax paid.

See also

References