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 the 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.
The Federal Income Tax
The income tax imposed on wages, salaries, and other compensation is calculated on Form 1040 each year. The total amount of your compensation appears in box 1 on the 2020 Form W-2.
The federal income tax system is progressive—the rates gradually become higher as your income increases, but various deductions and exemptions can reduce the federal income tax owed by reducing the amount of taxable income. Tax credits can be applied to the tax you owe just as though you had made a payment to the IRS.
Federal Income Tax Withholding
Total income tax withheld from your pay by your employer appears in box 2 of Form W-2. The amount is based on the information you provided on the Form W-4 you would have filled out when you started the job. It might be more or less than the amount of federal tax that will be due to the government at the end of the year when you file your tax return. Your employer remits this money to the IRS on your behalf.
Employees can change the amount of federal income tax withheld from their paychecks by adjusting the information provided 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, as are some health insurance and group life insurance premiums paid by your employer. Dependent care reimbursement accounts and adoption assistance aren't typically considered taxable income, either.
The Medicare Tax
Adjusting your withholding only affects federal and state income tax withholding, not Social Security and Medicare withholdings because these taxes are applied at a flat rate for all taxpayers. Medicare and Social Security taxes are collectively referred to as "FICA" taxes.
The Medicare tax is a flat tax on all compensation income, which is located in box 5 of your W-2. The rate is 2.9% as of 2020. Half the Medicare tax, or 1.45%, is paid by the employer. The other 1.45% is paid by the employee. Medicare tax is also deducted from an employee's total compensation as payroll withholding each pay period.
An additional Medicare tax of .9% can apply to those whose incomes exceed $200,000 as of 2020. This increases to $250,000 for married taxpayers who file jointly, but it drops to just $125,000 if you're married but file a separate return.
The Social Security Tax
The Social Security tax is also a flat-rate tax of 12.4% on all compensation income up to a wage base set by the Social Security Administration (SSA) each year. Like the Medicare tax, half the Social Security tax is paid by the employer and half by the employee—6.2% of the employee's compensation by each.
The Social Security tax rate was reduced to 10.4% for 2011 and 2012 with the employer paying 6.2% and employees paying 4.2%, but it went back up to 12.4% in 2013.
This tax has a maximum cap—the "wage base"—of $137,700 in earnings for 2020. This increases to $142,800 in 2021. The amount that appears in box 3 of your Form W-2 should not be more than $137,700 in the 2020 tax year for this reason. You only have to pay the Social Security tax on compensation and earnings up to this amount.
It's possible that you could be taxed on more than the year's wage base if you work for more than one employer and they're each withholding Social Security tax up to the base. You can claim a refund from the IRS when you file your tax return if you pay too much, or keep track of your earnings and alert your employers to stop withholding when your total income from all jobs reaches this figure.
Compensation That's Exempt From FICA Taxes
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 $6,000 as of 2020, or $3,000 for taxpayers who are married but file separately
- Educational assistance up to $5,250 as of 2020
- 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. The payroll withholding tables are graduated based on income, so 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 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 their wage income from all jobs on their 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% as of 2020. Other states have graduated, progressive tax rates like that of the federal government.
Nine states have no income tax on earned income at all: 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 beginning in 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. Local taxes are imposed at the city level in Ohio, while other taxes are imposed at the county level, such as in Indiana. Still other taxes are set by school districts. This is the case in Iowa.