How Social Security Tax Works


The Social Security system helps those who have retired and those who have suffered serious injury or illness, as well as their families.
The Social Security system helps those who have retired and those who have suffered serious injury or illness, as well as their families.
Comstock/Getty Images

The U.S. Social Security system acts as a giant safety net, providing financial assistance to people who have reached retirement age and younger folks who have suffered a serious injury or illness. It also helps out the family members of those who experience death or disability. Medicare, a health insurance program that covers most Americans over age 65 as well as some disabled people, is also part of the safety net. All told, Social Security represents a very large helping hand -- paying out some $40 billion in benefits every year [source: socialsecurity.gov].

Of course, there's no such thing as a free lunch. All that money has to come from somewhere. If you're a working American, it comes directly from your paycheck. Technically, it's dispersed from the Social Security Trust Fund, but the fund is filled by taking a percentage out of everyone's paycheck. Since the program's inception in the 1930s, more workers have paid into the fund than retired people drawing money from it. However, increased life expectancy and the Baby Boomer generation have been shifting the ratio. In fact, the government predicts that the Social Security Trust Fund could start running out of money in 30 to 40 years. That means that someday, the percentage taken out of your paycheck could increase to extend the life of the fund.

While Social Security taxes seem pretty straightforward -- the percentage taken is the same for almost everyone up to a certain income level -- a closer look at the system raises a lot of questions. Who determines the percentage taken from each paycheck? How is the cost-of-living increase determined? Why are Social Security taxes sometimes considered regressive? How much do I have to pay into the system to qualify for Social Security benefits? How long should I wait before I retire? We'll tackle these taxing questions and more.

 

15.3 Percent, Any Way You Cut It

As of 2010, the government takes 15.3 percent out of every working American's paycheck for Social Security taxes -- including both Social Security and Medicare. If you're an employee, half of that amount is deducted from each and every paycheck. The other half is paid directly by your employer, which means that other half is essentially coming out of your pay as well. The difference is, the half your employer pays isn't considered part of your income, so it doesn't count toward the amount of Social Security tax you pay, nor does it count toward your income taxes.

If you're self-employed, you pay the entire 15.3 percent yourself, either at the end of the year when taxes are due or in quarterly payments throughout the year. However, you get to deduct half of that amount when you calculate your income taxes, so you get the same tax benefit as if an employer had paid it.

Where does the 15.3 percent rate come from? It's made up of the 12.4 percent that goes to Social Security and the 2.9 percent reserved for Medicare. That rate is set by the Federal Insurance Contributions Act (FICA). FICA includes measures to reflect inflation of cost-of-living increases (COLA) automatically, so Congress doesn't have to pass or amend the law every time the amount needs to change. Social Security benefits increase to keep pace with COLA according to the Consumer Price Index for Urban Wage Earners and Clerical Workers [source: socialsecurity.gov]. Social Security taxes, in turn, increase along with inflation by raising the income cap according to average national wages.

The income cap is the maximum amount of income subject to Social Security taxes. There's no cap on Medicare taxes. The official term for this cap is the Social Security Wage Base. In 2010, this cap was $106,800. What the cap means is that you pay your half of the 12.4 percent (or the whole thing if you're self-employed) only on the first $106,800 you make. Any income above that level isn't subject to Social Security taxes. If you're an employee who earned $106,800 in 2009, you'll pay $6,621.60 in Social Security taxes. Your employer pays that same amount. If you earned $50 million in 2009, you'll still pay $6,621.60 in Social Security taxes. Since wages tend to rise (gradually) due to inflation, tying the cap to average wages roughly allows the amount of Social Security taxes collected to stay on par with inflation.

Of course, the full story of Social Security taxes isn't quite that simple. Next, we'll look at exceptions, exemptions and other situations where the tax rate isn't so clear-cut.

Exceptions and Exemptions

There are certain situations when you don't have to pay Social Security taxes on your income. The most common is when you're retired or disabled, and some portion of your salary comes from Social Security itself. This is where things get a little complicated.

You never pay taxes on more than 85 percent of your Social Security income -- no matter what. So if you received $10,000 in benefits in a year, you'd have to pay 6.2 percent of $8,500. Here's how the tax rate breaks down for different people in different situations:

  • If you file an individual tax return, you could pay taxes on up to 50 percent of your Social Security benefits if your combined income is between $25,000 and $34,000.
  • If you file an individual tax return, you could pay taxes on up to 85 percent of your Social Security benefits if your combined income is more than $34,000.
  • If you and your spouse file a joint tax return, you could pay taxes on up to 50 percent of your Social Security benefits if your combined income is between $32,000 and $44,000.
  • If you and your spouse file a joint tax return, you could pay taxes on up to 85 percent of your Social Security benefits if your combined income is above $44,000.
  • If you're married, but you and your spouse file separate individual tax returns, you could pay taxes on up to 85 percent of your Social Security benefits regardless of income levels.

What's your combined income, anyway? That's your adjusted gross income (income minus tax deductions) plus nontaxable interest (from bonds and other financial instruments) plus 50 percent of your Social Security benefits. This might seem confusing, but just remember that the term "combined income" has nothing to do with whether or not you and your spouse filed individual returns. It's just the sum of all your various sources of income and half of your Social Security benefits.

There are a few other exceptions to Social Security tax laws. Members of certain religious groups don't have to pay, but they don't receive benefits either. Some government employees have their own retirement and insurance systems, so they don't pay into or draw benefits from Social Security. Income below certain earning thresholds isn't subject to the tax, either. The exact amount depends on the job -- it's different for self-employed people, election workers and live-in maids, for example. Many student jobs are exempt, including Federal Work Study jobs and graduate student stipends [source: IRS].

Now that we've talked about taxation, how do you get some of that money back? In the next section, we'll cover Social Security benefits.

Social Security Benefits

Social Security benefit checks run through a printer at a U.S. Treasury facility in Philadelphia, Penn.
Social Security benefit checks run through a printer at a U.S. Treasury facility in Philadelphia, Penn.
William Thomas Cain/Getty Images

To qualify for full Social Security retirement benefits, you need to have at least 10 credits in the Social Security system. How do you earn credits? You earn one for each quarterly period that you work and contribute to the system, but there's a minimum amount you must earn to receive the credit. The amount changes each year. The minimum amount needed to earn a credit in a quarter in 2010 was $1,120. To get the yearly maximum of four credits, you need to have earned $4,480 in 2009. Note that the term "quarter" is somewhat archaic, since the government doesn't count separate quarters anymore. Your income is counted for the entire year, and you get one credit for each $1,120 you earn, up to a maximum of four credits each year. It doesn't matter when in the year you earned that income. If you make $5,000 in January, you'll still get four credits for that year. If for some reason you need to collect Social Security before you have a full 10 credits, you may get some reduced benefits.

How much will you receive in retirement benefits? The amount is first based on your average wages over the 35 years of your life in which you earned the most, adjusted for inflation. It's then adjusted based on when you retire. You can retire as early as age 62, but you'll receive reduced benefits. You have to reach full retirement age to get the full benefits -- this age is between 65 and 67, depending on when you were born. You can even delay retirement beyond full retirement age to get increased benefits [source: socialsecurity.gov].

If you're wondering how many credits you have, the Social Security Administration sends an annual statement to everyone over the age of 25 who has paid into the system. It will explain how many credits you have earned so far, what your benefits would be under your current number of credits and your earnings for each year you've paid into the system. If you're already retired and receiving Social Security benefits, your statement serves another important function: It shows you the exact benefits you received in a given year, which you can use to calculate your combined income.

If you need an extra Social Statement for any reason, you can request one from the Social Security Administration here.

For more information on taxes, please see the links on the next page.

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Sources

  • Internal Revenue Service. "Taxable Income for Students." Accessed March 15, 2010. http://www.irs.gov/individuals/students/article/0,,id=96674,00.html
  • Social Security Online. "Information about Requesting a Social Security Statement." Accessed March 15, 2010.https://secure.ssa.gov/apps6z/isss/main.html
  • Social Security Online. "Your Retirement Benefit: How It Is Figured." Jan. 2010, Accessed March 15, 2010.http://www.socialsecurity.gov/pubs/10070.html
  • Social Security Online. "Social Security Announces 5.8 Percent Benefit Increase for 2009." Accessed March 15, 2010.http://www.ssa.gov/pressoffice/pr/2009cola-pr.htm
  • Social Security Online. "SSI Annual Statistical Report, 2008." Sept. 2009, Accessed March 15, 2010.http://www.ssa.gov/policy/docs/statcomps/ssi_asr/