Preface: “I pay my income tax and the government gives back what I got coming. Lord, but it ain’t much.” — Merle Haggard
Social Security – How Earned Income is Taxed to Fund Social Security
The following is the fifth in a series of blog posts on the subject of Social Security. The first four installments, which can be found here, here, here, and here:
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- Reviewed the history of the Social Security program
- Explained how to claim Social Security retirement benefits
- Explained how to claim Social Security survivor and family member benefits
- Explained how Social Security benefits are taxed
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This fifth installment will discuss:
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- How earned income is taxed to fund Social Security
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Future posts in this series will address:
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- Estimating Social Security’s returns on investment
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The Bi-Weekly Bite
If you look closely at your bi-weekly paycheck, you will see a large hole. This hole is the gap between gross pay and net pay. The teeth marks reveal the identity of the biters. One of the largest is almost always “OASDI” a.k.a. Social Security. It is equal to 6.2% of your gross. Another hungry mouth is Medicare at 1.45%. Together, these make up the 7.65% employee half of FICA. If your gross was $10,000, you paid $765 in employee FICA.
As noted in a previous post in this series, FICA stands for Federal Insurance Contributions Act. It was introduced to fund the Old Age, Survivors, and Disability Insurance (OASDI) benefits established by the Social Security Act of 1935. At the time of its creation, FICA was set at 2%, but is now 15.3% of wages and self-employed income.
“No problem,” you might be thinking, “I’ll get some of it back as a refund when I file my taxes, right?” WRONG. FICA is non-refundable. Regular income tax in excess of your tax liability is an easy refund. But FICA and regular income tax are two parallel but separate tax systems computed under different rules.
If you have no income tax liability for the year, you will be refunded whatever was withheld for regular income tax purposes, $235 in the above example. If you have some income tax liability but less than your withholding, you will be refunded the difference. But this does not apply to FICA withholding because FICA is used to fund Social Security benefits, not to offset income tax liability.
Furthermore, many types of payroll deduction such as pensions and health savings accounts will reduce your income that is subject to income tax. But nothing will reduce your income subject to FICA:
Notice that deductions for your pension and other benefits reduce your wages subject to income tax, but do not reduce your wages subject to FICA. FICA is computed as a percentage of your gross pay before other deductions.
How the Other Half Bites
But that is only half the damage done by FICA. In the above examples, your employer paid the full $10,000 of employee gross pay and is allowed to deduct it as a business expense. However, your employer also paid the employer half of FICA and it is allowed to deduct that as well. In other words, for every $10,000 you see in gross pay, your employer had to pay that plus another $765 that that you don’t even see.
So, for every $10,765 your employer pays to employ you, the government gets $1,530 in FICA while $9,235 is left over for you. Out of this you must then pay your regular income tax on a wage base considered to be $10,000.
“No problem,” you might be thinking, “The employer half of FICA is my boss’s problem, not mine.” But from your employer’s point of view, this is money paid to employ you. It is effectively part of your compensation package. In the end, it is that much less money that is left over that can be offered to you as take-home pay or benefits.
How FICA is Collected from the Self-Employed
If you are self-employed, you must pay both the employee and the employer halves of FICA in the form of self-employment tax. You do get to deduct the employer half from the amount of your income that is subject to regular income tax.
For the self-employed, if you have at least $400 in self-employed income, you must file an income tax return for the year even if you are not otherwise required to file. This is because you must pay the self-employment tax even if you have no ordinary tax liability.
This is similar to how FICA withholding for employees is not refundable even when they have no regular income tax liability. Employees do not even get the $400 safe harbor. Even if you only earned $1 at your job, 15.3¢ is getting collected in FICA. It respects neither the standard deduction, itemized deductions, student loan interest, child tax credit, or section 11 bankruptcy.
You may not think the term “self-employed” will ever apply to you. But if you receive any payment for work you did as a non-employee, you are subject to self-employment tax. This could be anything from babysitting or mowing lawns or selling popcorn at a sports event, to consulting fees or contract labor.
What Happens to FICA after It Is Collected?
“No problem,” you might be thinking, “I’ll get all that FICA back when I retire and collect my Social Security benefits.”
Well, maybe. But first, you have to live long enough to collect it. Not everybody does.
Second, even though Social Security is described as a trust fund held to pay out benefits, it is important to understand what this means and what it doesn’t mean. The U.S. Supreme Court has ruled in Flemming v. Nestor (1960) that paying into Social Security does not mean you have a legal claim to benefits. In other words, it is illegal for the government to use FICA money for any other purpose than to pay Social Security benefits. But there is no legal requirement that they pay the benefits. As far as who gets the benefits, it is first come first served. And there is no reason to assume there will be enough left for you when the time comes, even if you do live that long.
Third, and this will be the topic of a future post in this series, how much are those benefits worth compared to what you paid in over the course of your working life?
Monthly and Quarterly Payments and Filing Requirements
In addition to the financial toll it imposes, FICA also places reporting and remittance burdens on employers and the self-employed that raise the barriers to doing business and are likely a significant inhibitor to business formation in the United States. Businesses that do get off the ground must continually devote time, effort, and resources to monitoring their own compliance or paying third parties to assume these responsibilities for them.
Since employees have their share of FICA taken out of their wages by their employer in each pay cycle, they are not required to make any additional FICA-related payments or reports.
Employers are required to remit both their half and their employees’ half of FICA to the government on at least a monthly basis and to report the totals on Form 941 on a quarterly basis. Penalties for failing to make the required payments and filings are severe. This applies to all employers from the largest mega-corporation down to the smallest food truck.
The self-employed are required on a quarterly basis to pay estimates towards their expected annual amount of self-employment tax. You will incur penalties for not paying sufficient estimates in a timely manner even if you do not end up owing any income tax. Penalties on the self-employed will be waived if the annual shortfall is less than $1,000, or less than 10% of annual tax liability, or if the total of the year’s estimated payments would have covered the prior year liability.
The damage done by FICA to employers, employees, and to the self-employed is real and cuts deep: 15.3% of income wiped out before income tax or other deductions are even considered, let alone money left to pay for food, housing, clothing, or personal savings. FICA eats away your ability to generate capital, buy a home, start your own businesses, and leave something to your children. Unlike regular income tax, it cannot be refunded or abated or challenged by appeal or in tax court.