Taxation

Tax on wages and self-employment income

Benefits are funded by taxes imposed on wages of employees and self-employed persons. As explained below, in the case of employment, the employer and employee are each responsible for one half of the Social Security tax, with the employee's half being withheld from the employee's pay check. In the case of self-employed persons (i.e., independent contractors), the self-employed person is responsible for the entire amount of Social Security tax.

The portion of taxes collected from the employee for Social Security are referred to as "trust fund taxes" and the employer is required to remit them to the government. These taxes take priority over everything, and represent the only debts of a corporation or LLC that can impose personal liability upon its officers or managers. A sole proprietor and officers of a corporation and managers of an LLC can be held personally liable for non-payment of the income tax and social security taxes whether or not actually collected from the employee.

The Federal Insurance Contributions Act (FICA) (codified in the Internal Revenue Code) imposes a Social Security withholding tax equal to 6.20% of the gross wage amount, up to but not exceeding the Social Security Wage Base ($97,500 for 2007; $102,000 for 2008; and $106,800 for 2009, 2010, and 2011). The same 6.20% tax is imposed on employers. For 2011 and 2012, the employee's contribution was reduced to 4.2%, while the employer's portion remained at 6.2%. In 2012, the wage base increased to $110,100. In 2013, the wage base increased to $113,700. For each calendar year for which the worker is assessed the FICA contribution, the SSA credits those wages as that year's covered wages. The income cutoff is adjusted yearly for inflation and other factors.

A separate payroll tax of 1.45% of an employee's income is paid directly by the employer, and an additional 1.45% deducted from the employee's paycheck, yielding a total tax rate of 2.90%. There is no maximum limit on this portion of the tax. This portion of the tax is used to fund the Medicare program, which is primarily responsible for providing health benefits to retirees.

The Social Security tax rates from 1937–2010 can be accessed on the Social Security Administration's website.

The combined tax rate of these two federal programs is 15.30% (7.65% paid by the employee and 7.65% paid by the employer). In 2011-2012 it temporarily dropped to 13.30% (5.65% paid by the employee and 7.65% paid by the employer).

For self-employed workers (who technically are not employees and are deemed not to be earning "wages" for federal tax purposes), the self-employment tax, imposed by the Self-Employment Contributions Act of 1954, codified as Chapter 2 of Subtitle A of the Internal Revenue Code, 26 U.S.C. §§ 1401–1403, is 15.3% of "net earnings from self-employment." In essence, a self-employed individual pays both the employee and employer share of the tax, although half of the self-employment tax (the "employer share") is deductible when calculating the individual's federal income tax.

If an employee has overpaid payroll taxes by having more than one job or switching jobs during the year, the excess taxes will be refunded when the employee files his federal income tax return. Any excess taxes paid by employers, however, are not refundable to the employers.

Wages not subject to tax

Workers are not required to pay Social Security taxes on wages from certain types of work:

Wages received by certain state or local government workers participating in their employers' alternative retirement system.

Net annual earnings from self-employment of less than $400.

Wages received for service as an election worker, if less than $1,400 a year (in 2008).

Wages received for working as a household employee, if less than $1,700 per year (in 2009–2010).

Wages received by college students working under Federal Work Study programs, graduate students receiving stipends while working as teaching assistants, research assistants, or on fellowships, and most postdoctoral researchers. Eliminated starting January 2011.

Earnings received for serving as a minister (or for similar religious service) if the person has a conscientious objection to public insurance because of personal religious considerations.

Federal income taxation of benefits

Originally the benefits received by retirees were not taxed as income. Beginning in tax year 1984, with the Reagan-era reforms to repair the system's projected insolvency, retirees with incomes over $25,000 (in the case of married persons filing separately who did not live with the spouse at any time during the year, and for persons filing as "single"), or with combined incomes over $32,000 (if married filing jointly) or, in certain cases, any income amount (if married filing separately from the spouse in a year in which the taxpayer lived with the spouse at any time) generally saw part of the retiree benefits subject to federal income tax. In 1984, the portion of the benefits potentially subject to tax was 50%. The Deficit Reduction Act of 1993 set the portion to 85%.

Criticisms

Claim that it discriminates against the poor and the middle class

Workers must pay 12.4 percent, including a 6.2 percent employer contribution, on their wages below the Social Security Wage Base ($110,100 in 2012), but no tax on income in excess of this amount. Therefore, high earners pay a lower percentage of their total income because of the income caps; because of this, and the fact there is no tax on unearned income, social security taxes are often viewed as being regressive. However, benefits are adjusted to be significantly more progressive, even when accounting for differences in life expectancy. According to the non-partisan Congressional Budget Office, for people in the bottom fifth of the earnings distribution, the ratio of benefits to taxes is almost three times as high as it is for those in the top fifth.

Despite its regressive tax formula, Social Security benefits are calculated using a progressive benefit formula that replaces a much higher percentage of low-income workers' pre-retirement income than that of higher-income workers (although these low-income workers pay a higher percentage of their pre-retirement income). Supporters of the current system also point to numerous studies that show that, relative to high-income workers, Social Security disability and survivor benefits paid on behalf of low-income workers more than offset any retirement benefits that may be lost because of shorter life expectancy (this offset would only apply at a population level). Other research asserts that survivor benefits, allegedly an offset, actually exacerbate the problem because survivor benefits are denied to single individuals, including widow(er)s married fewer than nine months (except in certain situations), divorced widow(er)s married fewer than 10 years,and co-habiting or same-sex couples, unless they are legally married in their state of residence. Unmarried individuals and minorities tend to be less wealthy.

Social Security's benefit formula provides 90% of average indexed monthly earnings (AIME) below the first "bend point" of $791/month, 32% of AIME between the first and second bend points $791 to $4781/month, and 15% of AIME in excess of the second bend point up to the Ceiling cap of $113,700 in 2013. The low income bias of the benefit calculation means that lower paid worker receives a much higher percentage of his or her salary in benefit payments than higher paid workers. Indeed, a married low salaried worker can receive over 100% of their salary in benefits after retiring at the full retirement age. High-salaried workers receive 43% or less of their salary in benefits despite having paid into the "system" at the same rate—(see benefit calculations above.) To minimize the impact of Social Security taxes on low salaried workers the Earned Income Tax Credit" and the Child Care Tax Credit were passed, which largely refund the FICA and or SECA payments of low-salaried workers through the income tax system. By Congressional Budget Office (CBO) calculations the lowest income quintile (0-20%) and second quintile (21-40%) of households in the U.S. pay an average federal income tax of -9.3% and -2.6% of income and Social Security taxes of 8.3% and 7.9% of income respectively. By CBO calculations the household incomes in the first quintile and second quintile have an average total federal tax rate of 1.0% and 3.8% respectively. However, these groups also have by far the smallest percentage of American household incomes – the first quintile earns just 3.2% of all income, while the second quintile earns only 8.4% of all income. Higher-income retirees will have to pay income taxes on 85% of their Social Security benefits and 100% on all other retirement benefits they may have.