As an employee, your labor is compensated in the form of wages, salary, and/or tips. That compensation is taxed for various federal and state taxes. Some of these taxes are paid by the employee through withholding, and some are paid by the employer. There are at least four federal taxes imposed on wage and salary income, plus any state and local taxes.
Federal Income Tax
The US federal government imposes income tax on wages and salaries. This is the tax that is calculated on the Form 1040 each year. The federal income tax rate gradually or progressively becomes higher as income rises, and various deductions, exemptions, or tax credits lower the federal income tax. Federal income tax is deducted from an employee’s total compensation in the form of payroll withholding. Be aware that the amount of tax withheld on wages might be higher or lower than the actual amount of federal tax due to the government. The actual amount of federal income tax is calculated on the Form 1040. Every employee can change the amount of federal income tax deducted from each paycheck by adjusting the number of withholding exemptions by using Form W-4. This form, the W-4, can be changed at any time during your employment. Adjusting your withholding will change only federal and state income tax withholdings, not your Social Security and Medicare withholdings.
The Medicare tax is a flat tax at a rate of 2.9% on all compensation income. Half of the Medicare tax, or 1.45%, is paid for by the employer. The other half of the Medicare tax, also 1.45%, is paid for by you, the employee. Medicare tax is deducted immediately from an employee’s total compensation as payroll withholding.
Social Security Tax
The Social Security tax is a flat rate tax with a maximum cap. The Social Security tax is a flat 12.4% on all compensation income, up to a maximum compensation amount of $118,500 for 2015. This $118,500 amount is called the Social Security wage base. The wage base amount is set each year by the Social Security Administration. Like the Medicare tax, the Social Security tax is paid for half by the employer and half by the employee. The employer pays 6.2% of an employee’s compensation for Social Security, and the employee pays 6.2%.
For 2011 and 2012 only, the Social Security tax rate was reduced to 10.4%, with the employer paying 6.2% and employees paying 4.2%.
Compensation Exempt from Social Security and Medicare Taxes
There are only a handful of wage compensation items that can be exempt from the Social Security and Medicare taxes:
- Reimbursements from the employer to the employee under an accountable plan,
- Wages paid to children age 17 or younger employed by their parent,
- Medical insurance premiums (both employer-paid and employee-paid),
- Employer contributions to a retirement savings plan,
- Group-term life insurance up to $50,000 in coverage,
- Contributions to a health savings account,
- Long-term sick pay (after 6 months since the employee last worked),
- Certain types of wages received by students for working through their university or college.
- Achievement awards of tangible personal property up to $1,600,
- Value of athletic facilities operated by an employer for the sole use of employees, their spouses and dependents,
- Dependent care benefits up to $5,000 ($2,500 for married filing separately),
- Educational assistance up to $5,250,
- Employee discounts up to 20% percent,
- Employer-provided cell phones if provided for noncompensatory business reasons,
- Employer-provided lodging on business premises if provided as a condition of employment,
- Meals if provided by employer on company premises for the convenience of the employer, and
- Transportation benefits for commuter highway vehicles, transit passes, parking, and bicycle commuting expenses.
(Source: Publication 15-B)
State Income Tax
State governments impose income taxes on wages and salaries much in the same way that the federal government does. Some states have a flat tax rate (such as Pennsylvania‘s 3.07% flat rate), other states have progressive or graduated tax rates, and still other states have no income tax at all. Many states will utilize the federal taxable wage amount when computing state taxes, while other states will have a separate calculation for what constitutes taxable wages.
State Mandatory Insurance Taxes
Several states fund social insurance benefit programs through taxes on wages and salaries. Examples include the state disability insurance funds operated by California and New York.
City, County and School District Income Taxes
Cities and localities throughout the nation impose their own income taxes. 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), other taxes are imposed at the county level (such as Indiana), while other taxes are set by a school district (as in Iowa).
More about city and local taxes.
Employer-Only Taxes on Salary and Wages
In addition to taxes that are imposed on the employee, the employer incurs additional taxes on wages.
Federal Unemployment Insurance at a rate of 6.2% is imposed on the first $7,000 of wages. The federal 6.2% rate can be reduced to as low as 0.8% based on contributing to a state unemployment insurance fund.
State Unemployment Insurance rates vary by state but is often imposed on the same $7,000 wage base.
Taxes on Tip Income
Tips are taxable in the same ways that wages are taxed. Employees receiving at least $20 in tip income per month are required to report the total amount of tips received to their employer so that taxes can be calculated and withheld. Any tips unreported to the employer are still reported on your tax return (as additional wages on Form 1040, line 7) and you’ll also calculate any Social Security and Medicare taxes due on those tips (Form 4137).
Overtime, Bonuses and Other Supplemental Wages
Bonuses and overtime are taxed the same way as wages. Since the payroll withholding tables are graduated based on income, overtime and bonuses might attract higher federal and state income tax withholding compared to your regular pay.
Switching Employers or Working for More than One Employer in a Year
Because of the graduated tax rates built into the payroll withholding tables issued by the IRS, when an employee starts working for a new employer or takes on a second job, there’s the possibility that federal and state income tax withholding might be lower than the amount of tax actually due. Employees working a second job can mitigate against this possibility by claiming zero withholding allowances on their W-4, or by requesting that additional tax be withheld over and above the withholding amount.
Similarly, there is the possibility that an employee might overpay Social Security taxes if, when combined, the wages from several jobs exceeds the Social Security wage base. In that case, the employee will receive the overpaid Social Security tax as an additional refund when filing a tax return.
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 deduction on a pay stub, which is issued to the employee at the same time that the wages are paid. Secondly, after the year is over the employer will report the total amount of wage income and tax withholding on Form W-2. A copy of the W-2 is also sent to the Social Security Administration and to the IRS. Thirdly, an employee will report their wage income from all jobs on their annual federal and state tax returns.