FICA stands for Federal Insurance Contributions Act and consists of a Social Security tax and a Medicare tax. Social Security tax is 6.2% and Medicare tax is 1.45% for a combined FICA tax rate of 7.65%.
FICA 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.
Maximum Taxable Income Amount For Social Security Tax
In 2023, employees are required to pay a 6.2% Social Security tax (with their employer matching that payment) on income up to $160,200, up from $147,000 in 2022, and up from $142,800 in 2021. The maximum income amount for Social Security tax tends to follow inflation up every year.
In other words, if you make $160,200, your maximum FICA tax will be $9,932.40. But don’t forget. You also have to pay a Medicare tax rate of 1.45%. Therefore, your total FICA tax rate is 7.65%. 7.65% X $160,200 = $12,255.3. If you are self-employed, you have to pay double (15.3%)!
Below is the historical maximum income amounts that that must pay Social Security Tax. FICA stands for Federal Insurance Contributions Act, which includes 6.2% for Social Security Tax and 1.45% for Medicare tax.
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.
Maximum Social Security Benefit Amount
The maximum benefit depends on the age you retire. For example, if you retire at full retirement age in 2023, your maximum benefit would be $3,627. However, if you retire at age 62 in 2023, your maximum benefit would be $2,572. If you retire at age 70 in 2023, your maximum benefit would be $4,555.
The maximum monthly Social Security benefit that an individual can receive per month back in 2021 was $3,790 for someone who files at age 70. For someone at full retirement age, the maximum amount is $3,011, and for someone aged 62, the maximum amount is $2,265.
The Best Income To Earn
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, $112,300 of the earnings is free from the 6.2% FICA 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.
Here are the 2023 tax brackets so you can plan how much time and energy you want to spend making money. Contrary to popular belief, earning as much income as possible may not be the best income due to taxes.
If You Pay More Social Security Tax, You Earn More Social Security Benefits
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 gets FICA-taxed on all of his earnings and then gets capped on Social Security benefits. He's just getting the maximum Social Security payout amount when it comes time.
The $500,000 income earner is already paying the highest marginal federal tax rate of 37% plus state taxes, if applicable.
The 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).
Business Owners Establish S-Corps To Lower Their FICA Tax Liability
Having to pay the entire FICA tax rate is why some elect to establish S-Corps. S-corps allow owners to pay themselves a smaller salary in order to take as many distributions as possible. Again, 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. Therefore, 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 with the Net Investment Income Tax (NIIT).
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.
Here's another great chart on the historical Social Security's Maximum Taxable earnings, by yar.
A Strategy To Pay Less FICA Taxes
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 25% – 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. The reason bing 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, 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. Social Security is underfunded.
2) Make as much money as possible beyond the maximum taxable income limit for Social Security tax.
All About Earning Passive Investment Income
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 and lower long-term capital gains tax rates.
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.
Related post: When Is The Best Time To Take Social Security?
Wealth Building Recommendations
1) Manage Your Net Worth For Free.
In order to optimize your finances, you've first got to track your finances. I recommend signing up for Empower's free financial tools so you can track your net worth. You can also analyze your investment portfolios for excessive fees.
Finally, run your financials through their amazing Retirement Planning Calculator. Those who come up with a financial plan build much greater wealth over the longer term than those who don't!
2) Start A Business
A business is one of the best ways to shield your income from more taxes. You can either incorporate as an LLC, S-Corp, or simply be a Sole Proprietor. For sole proprietor, no incorporating necessary. Just be a consultant and file a schedule C.
Every business person can start a Self-Employed 401k where you can contribute up to $57,000 ($19,500 from you and ~20% of operating profits). All your business-related expenses are tax deductible as well. Simply launch your own website like this one in under 30 minutes to legitimize your business. Here's my step-by-step guide to starting your own website.
For more nuanced personal finance content, join 60,000+ others and sign up for the free Financial Samurai newsletter. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009. Everything is written based off firsthand experience.