Have you ever looked at your paycheck and wondered where all your hard-earned money goes? If you are like most people, you’ve seen that your take-home pay is often significantly less than what you would expect, given your gross salary.
That’s because several withholdings, including federal income tax, state income tax, Social Security tax, and Medicare tax, come from paychecks. It’s no wonder payroll deductions are confusing for many employees.
So, let's dive into key taxes that seem to eat away at your earnings.
Payroll tax: Withholdings you can’t ignore
Federal law requires employers to withhold employment taxes from employee pay. Employment taxes include federal income tax withholding and taxes for Social Security and Medicare.
But when it comes to all the taxes deducted from your pay, four main types affect most U.S. workers. Here’s a brief summary of each.
1. Federal income tax
First is federal income tax withholding, which the government uses to fund everything from national defense to public education. Ultimately, the total federal tax you pay each year depends on several factors, including your taxable income , filing status, and tax bracket .
- The W-4 form you fill out when you start your job helps your employer determine how much to withhold for federal taxes.
- It’s important to update your W-4 and adjust your withholding if needed when you experience significant life changes that could affect your tax situation, like getting married, having a child, or a second job. Other examples might include starting a business or receiving a large bonus or pay increase.
- Filling out the W-4 form incorrectly or failing to update it after major life changes can result in inaccurate withholding.
For example, some people withhold too much from their paychecks, resulting in large tax refunds. However, a big tax refund often means giving the government an interest-free loan.
Meanwhile, other people don’t withhold enough, which can lead to owing tax when tax season rolls around and, in some cases, potentially facing IRS underpayment penalties. That is why the IRS and others often recommend evaluating and adjusting your withholdings throughout the year. A tool on the IRS website can help you estimate your federal tax withholding.
2. State income tax
Next, there is state income tax. The amount of state income tax deducted from your pay varies depending on where you live and work.
- Some states, like Florida and Texas , don't have state income tax. Alaska, Nevada, New Hampshire, South Dakota, Tennessee, Washington, and Wyoming also don’t have personal income tax. Other states, like California and New York , for example, are known for higher state income tax rates.
- Several states are cutting income taxes for 2024. For example, as Kiplinger reported, Georgia has a new personal income tax rate designed to offer tax relief for its residents.
- Other states may have other mandatory payroll taxes. Washington state has a first-of-its-kind payroll tax to help residents cover long-term care expenses .
It’s important to remember that state income taxes provide revenue for state governments to fund essential public services and programs. These taxes allow states to invest in education, infrastructure, and other critical areas.
3. Social Security tax: Who pays FICA taxes?
Social Security is a confusing tax for some. It is part of what's known as FICA ( Federal Insurance Contributions Act ) taxes. Social Security taxes are collected to provide retirement, disability, and health benefits for eligible older adults. Both employees and employers pay Social Security taxes, each contributing an equal share.
- Employees pay 6.2% of their wages into this system up to a specific limit. The 2024 Social Security tax limit is $168,600.
- Self-employed individuals pay both the employee and employer portions of Social Security tax. However, half of the tax is deductible on federal returns if you're self-employed.
Some people think of the Social Security tax as mandatory retirement savings. (The system operates on a pay-as-you-go basis, with current workers' contributions supporting current beneficiaries while building credit toward their future benefits.) However, it should be noted that whether Social Security will remain solvent for future generations is a topic of ongoing debate. Some economists have suggested eliminating 401(k)s to help shore up Social Security.
Note: It’s also important for retirees and older adults to know that once they receive benefits, up to 85% could be subject to tax. For more information, see Taxes on Social Security: Five Things to Know.
4. Medicare tax
Then, there is the Medicare tax . The Medicare payroll tax funds the Medicare program, which provides health insurance for older adults over 65 and certain people with disabilities.
- Medicare taxes are part of FICA and are automatically deducted from employees' paychecks.
- Both employers and employees contribute to this tax, which is 2.9% of earned income and wages (1.45% paid by each).
- Unlike the Social Security tax, however, there is no income limit for Medicare tax, meaning all earned income and wages are subject to this tax. As mentioned, self-employed individuals pay 15.3% in self-employment taxes (12.4% Social Security, 2.9% Medicare) on net earnings.
Note: High-income earners may face two Medicare surtaxes. One is the 0.9% Additional Medicare Tax on earned income above $200,000 ($250,000 for married couples filing jointly). The other is a 3.8% Net Investment Income Tax (NIIT) on certain net investment income of individuals, estates and trusts above statutory threshold amounts. Both surtaxes are paid by the individual, with no employer contribution.
Voluntary deductions
While those four taxes are the main types taken from your paycheck, they are not the only payroll deductions affecting your take-home pay.
Many of us also have voluntary deductions from our pay for things like health insurance premiums, retirement contributions (like 401(k) plans) , and sometimes even union dues. While these aren't taxes, they still impact how much money you earn at work ends up in your bank account.
Taxes out of paycheck: Bottom line
Payroll tax deductions can be frustrating, but understanding how they work is essential in managing your finances. Additionally, it may help to consider your voluntary paycheck deductions as investments in your health and future financial security.
Still, it’s good to monitor your federal tax withholdings and always check your paycheck details to ensure your gross pay, paid time off and sick leave balances, and other key information are correct.
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