FICA stands for Federal Insurance Contributions Act and consists of a Social Security tax and a Medicare tax. This tax is very important for everyone to understand because so often we only think about federal tax rates and state income tax rates. The FICA tax is a big percentage of your total tax bill, especially for those making under six figures a year.
When I was making big bucks in finance, the tax bill was equally big bucks. The only saving grace was seeing my after tax paycheck increase after the maximum taxable income threshold for Social Security was breached each year. The tax amounts were jolting based on how inefficient the government was and still is with regards to spending our money.
In 2019, employees were required to pay a 6.2% Social Security tax (with their employer matching that payment) on income up to $132,900. Any earnings above that amount were not subject to the tax. The income level tends to increase roughly 2% a year due to inflation.
The flip side of this is that as the taxable maximum increases, so does the maximum amount of earnings used by the SSA to calculate retirement benefits. In 2019, the maximum monthly Social Security benefit for a worker retiring at full retirement age is $2,861.
Given we have a progressive tax system in America with Alternative Minimum Tax (AMT) and deduction phaseouts, I’ve calculated that the optimal Adjusted Gross Income is roughly $250,000, +/- $50,000. At $250,000, $131,500 of the earnings is free from the 6.2% Social Security tax.
Meanwhile, you still get most of your mortgage interest deduction, and only have to pay a slight amount of AMT, depending on the person. A $250,000 income is also high enough to live relatively comfortably in any part of the world.
Some might argue that the Social Security tax is regressive because it caps out. Why shouldn’t rich people pay more? Here’s the thing people might not understand. Social Security benefits cap out based on the maximum amount of Social Security tax contribution as well.
It’s not like someone who is making $500,000, and not having to pay the 6.2% Social Security tax on $381,500 of his earnings is getting extra benefits based off his $500,000 income. He’s just getting the maximum Social Security payout amount when it comes time for him to collect based on the maximum taxable income amount he contributes.
The $500,000 income earner is already paying the highest marginal federal tax rate of 39.6% plus state taxes, if applicable.
MEDICARE TAX RATE
The Medicare portion of the FICA tax is 2.9%, of which half (1.45%) is paid by employees and the other half by employers. Unlike Society Security, there is no limit on the amount of wages subject to the Medicare portion of the tax.
Also, the 6.2% Social Security tax is only half of the total tax amount. Employers actually have to pay the other half for you (6.2% employee + 6.2% employer = 12.4%), which means employees can look on the bright side and view the 6.2% employer’s tax portion as a “subsidized retirement benefit.”
If you’re self-employed, you’re really hosed because you are responsible for the entire FICA tax rate of 15.3% (12.4 percent Social Security plus 2.9 percent Medicare). Having to pay the entire FICA tax rate is why some elect to establish S-Corps and pay themselves a smaller salary in order to take as many distributions as possible, since distributions are not subject to FICA tax.
However, S-Corp owners with salaries that are too low in comparison to their total distributions run the risk of audits and penalties, so check with your accountant for guidance on your specific situation. The general income/distribution recommended ratio I’ve seen is 50%/50%. Remember, the government wants as much tax dollars from you as possible.
Meanwhile, if you earn over $200,000 as a single employee or over $250,000 as a married taxpayer, you are subject to an ADDITIONAL 0.9 percent Medicare tax. In other words, the employee now must pay 2.35% of his/her earnings to Medicare beyond $200,000/$250,000. The employer paid Medicare tax remains at 1.45%.
HISTORICAL MAXIMUM TAXABLE EARNINGS FOR SOCIAL SECURITY
As you can see from the above chart, the maximum taxable income has stayed the same during difficult years (2003-2004, 2009-2011), but always goes up over time.
FICA TAX STRATEGY
There’s a problem with the FICA tax because Social Security and Medicare are so poorly run by the government. The government itself estimates that Social Security is underfunded by around 30%. Either payouts must decrease by 30%, or the minimum age to start receiving Social Security must rise from age 62. The government currently considers 66 as the full retirement age. You will get 75% of the monthly benefit if you elected Social Security at age 62 given you will be getting benefits for an additional 48 months before turning 66.
Given it’s unlikely the government will reduce corruption or improve operational efficiency in our lifetimes (unless you think greed and desire will magically disappear from all politicians), the goal for everybody should be:
1) To pay as little FICA tax as possible, while also saving as much money as you can for retirement, given Social Security is underfunded.
2) Make as much money as possible beyond the maximum taxable income limit for Social Security tax.
The way to pay as little FICA tax as possible is to make as little wage income as possible. Earn money through investments, dividend income, annuities, CD interest income, distributions and so forth. Only earned income faces the Social Security and Medicare tax. Developing passive income streams provides a better return for your buck thanks to no FICA taxes.
Note the tax rate on long-term capital gains (holding an asset over one year) and qualified dividend income is as follows: 0% if a person is in the 10% and 15% tax brackets; 15% if the person is in the 25%, 28%, 33%, or 35% tax brackets; and 20% if the person is in the 39.6% tax bracket. In other words, along every single income spectrum, an individual will be paying less in long-term capital gains tax than any income tax, especially since the above figures are only for federal taxes.
The way to make as much money beyond the maximum taxable income limit as possible is why you’re here at Financial Samurai. Financial Samurai is all about making more money and growing your net worth. Savings is great, but it is not enough. There are numerous industries and jobs that pay multiple six figures a year. Real estate is an incredible asset class that is quite tax advantageous. And entrepreneurship income is not as limiting as employer income if you want to really try and make it big.
The people who pay the least amount of taxes as a percentage of their income either don’t make much money or thoroughly understand the tax rules way beyond the average person. Definitely spend a good amount of time studying your local state or country’s tax rules. It’ll save you a lot of money down the road.
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Updated for 2019 and beyond.