Taxation of Wage and Salary Income

3 Federal Taxes Are Collected From Wage and Salary Income

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An employee's labor is typically compensated in the form of wages, salary, and sometimes tips, commissions, fringe benefits, bonuses, and awards. All this compensation is subject to various taxes at both state and federal levels. At least three federal taxes are imposed on wage and salary income: income tax, Social Security tax, and the Medicare tax.

Federal Income Tax

The U.S. government imposes an income tax on wages and salaries. This is the tax that's calculated on Form 1040 each year, and it appears in box 1 on your Form W-2. The federal income tax system is progressive—tax rates gradually become higher as income rises, but various deductions, exemptions, or tax credits can reduce federal income tax owed by reducing the amount of taxable income.

Federal income tax is deducted from an employee's total compensation in the form of payroll withholding based on the information provided to the employer on his Form W-4. The amount of tax withheld on wages can be more or less than the amount of federal tax that will be due to the government at the end of the year. 

Employees can change the amount of federal income tax withheld from their paychecks by adjusting the number of withholding exemptions on Form W-4. This form can be changed at any time during your employment.

Some of your income might not be subject to withholding. Traditional 401(k) contributions are subtracted first before withholding is calculated. Some health insurance and group life insurance premiums paid by your employer might not be included in your income. Dependent care reimbursement accounts and adoption assistance are also not typically considered taxable income.

The Medicare Tax

Adjusting your withholding will only affect federal and state income tax withholding, not Social Security and Medicare withholdings.

The Medicare tax is a flat tax on all compensation income located in box 5 of your W-2. The rate is 2.9 percent as of 2019. Half the Medicare tax, or 1.45 percent, is paid by the employer. The other 1.45 percent is paid by the employee. Medicare tax is deducted from an employee's total compensation as payroll withholding each pay period.

An additional Medicare tax of .9 percent can apply to those whose incomes exceed $200,000. This increases to $250,000 for married taxpayers who file jointly, but it drops to just $125,000 if you are married but file a separate return. This tax applies to wages, self-employment income, and some railroad retirement compensation.

The Social Security Tax

The Social Security tax is also a flat rate tax but this one has a maximum cap of $132,900 as of 2019. The amount that appears in box 3 of your Form W-2 should not be more than this in the 2019 tax year. The cap is called the Social Security wage base, and it can be adjusted annually by the Social Security Administration.

It's possible that you could be taxed on more than the wage base if you work for more than one employer and they're each withholding up to the base. You can claim a refund from the IRS when you file your tax return if you pay too much, or just keep track of your earnings and alert your employers to stop withholding for Social Security when your total income reaches this figure.

Social Security tax is only collected from earnings up to $132,900 a year as of 2019. Make sure your employer is aware of this if your income approaches this figure.

The Social Security tax is 12.4 percent on all compensation income up to the wage base. Like the Medicare tax, half the Social Security tax is paid by the employer and half by the employee—6.2 percent of the employee's compensation by each. 

The Social Security tax rate was reduced to 10.4 percent for 2011 and 2012 with the employer paying 6.2 percent and employees paying 4.2 percent, but it went back up to 12.4 percent in 2013.

Compensation That's Exempt From Social Security and Medicare

A handful of compensation types are exempt from Social Security and Medicare taxes. They include: 

  • Reimbursements from an employer to an employee under an accountable plan
  • Wages paid to children age 17 or younger who are employed by their parents
  • Medical insurance premiums, both employer-paid and employee-paid
  • Employer contributions to a retirement savings plan
  • Contributions to a health savings account
  • Long-term sick pay after six months since the employee last worked
  • Certain types of wages received by students for working through their university or college
  • Dependent care benefits up to $5,000 as of 2019, or $2,500 for taxpayers who are married but file separately 
  • Educational assistance up to $5,250 as of 2019
  • Transportation benefits for commuter highway vehicles, transit passes, parking, and bicycle commuting expenses

Overtime and Other Supplemental Wages

Bonuses and overtime are taxed in the same way wages are. Because the payroll withholding tables are graduated based on income, overtime and bonuses can incur higher federal and state income tax withholding compared to your regular pay.

Reporting Wage and Salary Income

There are three reporting mechanisms for wage and salary income. First, employers report your pay and various tax deductions and other payroll deductions on a pay stub, which is issued to the employee at the same time wages are paid. Not all small employers do this, however. You might have to ask for an accounting by pay period.

Second, the employer will report the total amount of wage income and tax withholding on Form W-2 after the year has ended. A copy of the W-2 is also sent to the Social Security Administration and to the IRS.

Third, an employee will report her wage income from all jobs on her annual federal and state tax returns.

Income That's Not Subject to Federal Tax

Not all forms of income are taxable. Workers' compensation generally isn't, nor are welfare payments. Some qualified pension payments are exempt, particularly for public safety officers, as is child support.

State and Local Taxes

Most state governments impose income taxes on wages and salaries in much the same way the federal government does. Some states have a flat tax rate, such as Pennsylvania at 3.07 percent as of 2019. Other states have graduated, progressive tax rates like that of the federal government. 

Nine states have no income tax at all on earned income: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. Tennessee and New Hampshire tax only dividends and interest, and Tennessee won't even tax this income after 2021. 

Some cities and localities throughout the nation impose their own income taxes as well. New York City is perhaps the most famous example of a city income tax. Some local taxes are imposed at the city level such as in Ohio, while other taxes are imposed at the county level such as in Indiana. Still other taxes are set by a school district. This is the case in Iowa.