By Joel Chouinard, CFP®
September 12, 2023
Did you notice that your take-home paychecks have increased recently? If that’s the case, you may be wondering why, since the last time you checked, you hadn’t gotten a raise.
The answer is likely that you’ve maxed out your Social Security tax for the year.
Key Takeaways
- For 2023, once an individual taxpayer has earned $160,200, they have maxed out their Social Security tax*. Any dollars earned above that amount aren’t assessed the 6.2% tax.
- For self-employed individuals (e.g., law firm partners), the Social Security tax is 12.4%.
- The Medicare tax (1.45%) does not have a cap. The rate is 2.9% for self-employed individuals.
- The Additional Medicare tax (0.9%) and Net Investment Income tax (3.8%) are assessed in addition to the Medicare tax and also do not have a cap.
Most people understand that they have to pay federal and state taxes (unless you live in a state that does not levy a state tax, such as Texas and Florida). But what other taxes are assessed on earned income and how are they calculated?
What is the Social Security Tax?
Also known as the Old-Age, Survivors, and Disability program (OASDI), the Social Security tax is used to fund the well-known Social Security benefit (Old-Age), as well as survivor benefits and disability insurance benefits. To be eligible for these benefits, a taxpayer must pay into the program, via a tax, throughout their working career.
Thankfully, unless you are a self-employed individual (more on that below), your employer is equally responsible to fund this program on your behalf. Currently, employees and employers each have to pay a tax equal to 6.2% of the employee’s salary (for a total of 12.4%). To put this into actual numbers, if you make $100,000 a year, you will pay a $6,200 tax and your employer will pay a $6,200 tax.
However, the Social Security tax is capped. For the 2023 tax year, only the first $160,200 that an individual U.S. taxpayer earns gets assessed the Social Security tax. The easiest way to find out if you’ve maxed out the Social Security tax is to look at your most recent paystub and find your year-to-date (YTD) gross earnings. If you’ve earned more than $160,200 YTD, that is why your take-home paychecks are now bigger!
What benefits are attached to the tax?
Paying the Social Security tax entitles a taxpayer to receive certain benefits. The Social Security pension benefit is the most well-known of these benefits. The amount you receive depends on your age, how much you have paid into the program via the tax, how long you have worked, and when you start taking your benefit. Because the Social Security tax is capped, your benefits are also capped. For 2023, the maximum monthly benefit a recipient can receive is $4,555*.
The OASDI program also includes a survivor benefit. For example, if you pass away and leave behind a spouse and minor children, they are entitled to receive benefits. The tax also subsidizes the Social Security Disability Insurance program (SSDI), as well as the Supplemental Security Income (SSI).
To be entitled to these benefits, also known as becoming “fully insured”, a taxpayer must have earned a total of 40 credits. You receive each credit when you have earned $1,640 (indexed for inflation each year) up to a total of 4 credits per year. In other words, if you earn $6,560 in one year, you will receive all 4 credits for that year**. Therefore, it could take a taxpayer as early as 10 years to be fully insured into the program.
Note that the SSI program is not based on credits and is available to anyone.
Social Security Tax for Self-Employed Individuals
So far, we’ve discussed the Social Security tax from a W2 employee standpoint. But what happens when you are both the employee and the employer? This could be the case if you are a sole proprietor of a business, but also if you are in a partnership (e.g., partner at a law firm). Well, it’s pretty simple. If you are self-employed, you are responsible for both the employee and employer side of the tax for a total of 12.4%.
Two important things to note for self-employed individuals: (1) the tax is assessed only on 92.35% of your net earnings from self-employment (gross income minus business expenses); and (2) you are eligible to deduct half of the tax you paid as a business expense. Therefore, not all of your business income is factored in.
Also, remember that the Social Security tax is capped after an individual has earned $160,200 (for 2023), so any dollars earned above that amount are not assessed the 12.4% tax.
Medicare Tax
One thing we haven’t discussed yet is the Medicare tax. As the name implies, this tax is assessed to fund the Medicare program (medical insurance for people over 65). The tax rate for this program is 2.9% of earned income. If you are a W2 employee, the tax is once again split between you and your employer (1.45% each). If you are self-employed, you are responsible for the full 2.9%.
Note that there is no cap on the Medicare tax, so every dollar earned is assessed the tax.
Additional Medicare tax and Net Investment Income Tax
To pay for the expansion of Medicare under the Affordable Care Act (ACA), two new Medicare surtaxes were introduced in 2013.
1. Additional Medicare tax: This tax is assessed on high income earners. Single filers who earn above $200,000 and married couples filing jointly who earn above $250,000 are assessed an additional 0.9% tax. Note that this tax is only assessed on income earned above these thresholds. The first $200,000 (or $250,000 if married filing jointly) is taxed at 1.45% (2.9% for self-employed individuals), and any income earned above that is assessed both the regular and additional Medicare tax***. There is no employer portion of the Additional Medicare tax.
2. Net Investment Income Tax (NIIT): This tax is the equivalent of the Additional Medicare tax, but for unearned income (also known as investment income). Investment income can include taxable interest (from bonds, CDs, or savings accounts), dividends, nonqualified annuity gains, capital gains, and rental income***. The NIIT tax is 3.8% and is assessed on the lesser of net investment income, or the excess investment income above certain Modified Adjustable Gross Income (MAGI) thresholds. These thresholds are the same as the Additional Medicare tax ($200,000 for single filers and $250,000 for married couples filing jointly). For example, if a married couple earns $225,000 and has $50,000 of net investment income, the tax would be assessed on the lesser of $50,000 or $25,000 (excess investment income over the $250,000 threshold for married couples filing jointly)
Bottom line is if you are a high-income earner, you will likely notice that your take-home paycheck will increase at some point during the year because you have maxed out the Social Security tax. You can use that extra money to put toward your mortgage principal balance, pay down your student loans, increase your retirement savings, or use it to fund your next vacation!
*www.ssa.gov/oact/cola/cbb.html
** www.ssa.gov/myaccount/assets/materials/eligibility-for-benefits.pdf
*** www.investopedia.com/medicare-tax-definition
SharpEdge Financial LLC is a registered investment adviser registered with the State of Texas. Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned, such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment. The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.
SharpEdge Financial LLC is a registered investment adviser registered with the State of Texas. Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned, such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment. The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.