How FICA Works


What is FICA and why does it take such a huge chunk of your paycheck?
What is FICA and why does it take such a huge chunk of your paycheck?
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Payday in America is a bittersweet experience. At the end of a hard month's work, the office intern tosses an envelope in your cubicle containing a check (or pay stub) for a confusingly small amount. There's your gross income at the top with its nice round zeros, but what are all of these minus signs below it? Federal taxes, state taxes, local taxes -- fine, you know what those mean. But what is this last one called FICA? And why is it snatching up more than seven percent of your salary?

FICA stands for the Federal Insurance Contributions Act. FICA isn't exactly a tax; it's more like an involuntary contribution [source: Social Security Administration]. What's the difference, you ask? Taxes are collected by the federal, state and local government to pay for a wide variety of budget items, everything from national defense to the local library. FICA contributions, on the other hand, help pay for two specific federal programs: Social Security and Medicare. In fact, your paycheck might not say FICA at all. The same money might be withheld under acronyms like "SS," "SSWT" or "OASDI" [source: H&R Block].

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Social Security and Medicare are different from most federal programs because they are operated as trust funds. All working Americans pay into the Social Security and Medicare trust funds. At the same time, retired and disabled workers withdraw from these trust funds to collect Social Security and Medicare benefits. That's why FICA dollars withheld from your paycheck are less of a tax than a "contribution" into this pooled "social insurance" [source: Social Security Administration]. The hope is that the same Social Security and Medicare benefits will be there when you need them -- a hope we'll discuss a little later in this article.

The origins of FICA began with the Social Security Act of 1935, signed into law by President Franklin D. Roosevelt in the wake of the Great Depression. In 1939, Congress amended the act to move the tax component of Social Security into the Internal Revenue Code, where it could be collected by the IRS. Previously known as Title VIII of the Social Security Act, the tax provision was renamed the Federal Insurance Contributions Act to reflect its role in the new social insurance safety net [source: Social Security Administration]. Medicare was created in 1965 and Medicare contributions were folded into FICA.

Every working American makes FICA contributions, also known as payroll taxes. But not every worker pays the same percentage of his or her income. Wage and salary workers owe half as much as self-employed workers. Why the difference? We'll explain more on the next page.

FICA for Wage and Salary Employees

If you get a paycheck from an employer, then your FICA contribution is automatically withheld from every check. If you do the math, you will see that you pay 7.65 percent of your taxable earnings to FICA [source: Social Security Administration]. Interestingly, that is only half of the 15.3 percent in FICA contributions you owe to the federal government. Your employer is obligated to pay the other 7.65 percent for you. Isn't that nice of your corporate overlord? If you're high school or college student who also works for your school part-time, your wages are exempt from FICA taxes.

The 7.65 percent of your salary that you pay each month is earmarked for three different trust funds: two Social Security funds and one Medicare fund. Let's break down the FICA contribution into its three component parts:

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  • Old-Age and Survivors Insurance (OASI) – This Social Security trust fund pays benefits to retired workers and their families or the surviving family members of retired workers [source: Social Security Administration]. Exactly 5.3 percent of your salary is deposited in this fund.
  • Disability Insurance (DI) – This separate Social Security trust fund pays benefits to disabled workers and their families [source: Social Security Administration]. These are people who can't work because of a serious injury or permanent disability. Exactly 0.9 percent of your salary is deposited in this fund.
  • Hospital Insurance (HI) – This Medicare trust fund pays for Medicare Part A benefits, including inpatient hospital care, skilled nursing facility care, home health care and hospice care [source: Medicare.gov]. The fund also helps cover Medicare administrative costs. Exactly 1.45 percent of your salary goes into this trust fund.

Note that these rates were slightly lower for 2011 earnings.

The good news is that there is a limit to how much income can be taxed by the two Social Security trust funds. For 2012 earnings, that limit is $110,000 [source: Social Security Administration]. That means that only the first $110,000 of your income can be taxed the 6.2 percent that is earmarked for the OASI and DI trust funds. There is no limit, however, for Medicare, so you will always owe 1.45 percent for the HI trust fund.

Self-employed workers don't have the benefit of an employer who covers the other half of their FICA contributions, but they do get to deduct a portion of their payroll taxes. We'll talk more about it on the next page.

FICA for Self-Employed Workers

Income taxes are different for self-employed workers. If you are a sole proprietor of a business or an independent contractor, you don't receive a regular weekly or monthly paycheck from an employer who is obligated to withhold certain taxes, including FICA contributions. Instead, the IRS requires most self-employed workers to pay estimated taxes four times a year. This helps self-employed workers keep better track of their tax burden (no nasty surprises in April) and keeps money flowing into the Treasury year-round.

Technically, self-employed workers pay no FICA taxes at all. Or rather, they go by a different name. Self-employed workers pay a Self-Employment (SE) tax, which covers the same Social Security and Medicare contributions as FICA [source: IRS]. The downside of being self-employed is that you are responsible for paying the full 15.3 percent Self-Employment tax, whereas wage and salary employees only pay half for FICA. Self-employed people pay 10.6 percent of their salaries to the Old-Age and Survivors Insurance (OASI) fund, as well as 1.8 percent to the Disability Insurance (DI)fundand 2.9 percent for Hospital Insurance (HI).

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It's not all bad news for self-employed workers, though. For starters, you are able to deduct half of your Self-Employment tax from your adjusted gross income [source: IRS]. Additionally, some economists argue that wage and salary workers ultimately end up paying the other half of their payroll taxes, too, because employers keep salaries lower so they can cover their costs [source: Tax Policy Center].

For lots more information on income taxes, employment and the IRS, see the links on the next page.

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Sources

  • H&R Block. Tax Tips and Calculators. "Common Paycheck Stub Items" http://www.hrblock.com/taxes/tax_tips/tax_planning/understanding_paycheck.html
  • Internal Revenue Service. "Self-Employment Tax (Social Security and Medicare Taxes)" http://www.irs.gov/businesses/small/article/0,,id=98846,00.html
  • Pear, Robert. The New York Times. "Slow Recovery Worsens Financial State of Medicare." May 13, 2011 http://www.nytimes.com/2011/05/14/health/policy/14medicare.html?pagewanted=all
  • Medicare.gov. Centers for Medicare & Medicaid Services. "How is Medicare Funded?" May 2011 http://www.medicare.gov/Publications/Pubs/pdf/11396.pdf
  • Social Security Administration. "Contribution and Benefit Base" http://www.ssa.gov/oact/COLA/cbb.html#Series
  • Social Security Administration. "Disability Insurance Trust Fund" http://www.ssa.gov/oact/ProgData/describedi.html
  • Social Security Administration. Frequently Asked Questions. "What is the meaning of FICA?" October 25, 2011 http://ssa-custhelp.ssa.gov/app/answers/detail/a_id/392/~/what-is-the-meaning-of-fica
  • Social Security Administration. "Old-Age and Survivors Insurance Trust Fund" http://www.ssa.gov/oact/ProgData/describeoasi.html
  • Social Security Administration. "Social Security and Medicare Tax Rates" http://www.ssa.gov/oact/ProgData/taxRates.html
  • Tax Policy Center. "Tax Topics: Payroll Taxes" http://taxpolicycenter.org/taxtopics/Payroll-Taxes.cfm