The maximum amount of earnings subject to the 6.2% Social Security payroll tax climbed to a record $142,800 in 2021, up from $132,900 in 2019. Your goal should be to increase your investment income so you can earn more tax efficiently.
In other words, those lucky enough to have jobs and earn $142,800 or more will have to pay $8,853.60 a year in Social Security tax. This tax would be fine if Social Security was fully funded. However, at the current rate, retired citizens will only get about 75% of the expected payout by 2040.
But of course, you can’t forget about Medicare, which is 1.45% of all income earned. And Medicare doesn’t have an income cap. So the reality is that a $142,800 a year laborer will have to pay $8,853.60 in Social Security tax plus $2,070.60 in Medicare tax for a total of $10,924.20 in 2021. The maximum income for FICA tax will continue to go up each year.
If you are “unlucky” enough to be your own boss, you’ve got to pay the 6.2% Social Security tax + 1.45% Medicare tax times two (employer plus employee)! In other words, a self-employed individual making $142,800 will now have to pay over $21,848.40 a year in Social Security + Medicare tax.
And the great irony is, good luck trying to collect unemployment benefits if your business goes bust.
Social Security Is Not In Good Shape
Out of the estimated 173 million workers who will pay Social Security taxes in 2021, about 12 million (7%) will be paying more. But as I’ve shown you before, anybody who makes between $100,000 – $200,000 and lives in a large city is considered middle class. Therefore, we can conclude the middle class is getting punched in the face even harder.
Don’t forget, there’s also the 0.9% Additional Medicare Tax on employees that went into effect in 2013. If you make more than the below thresholds, you’ve got to pony up 2.35% in Medicare taxes (1.45% standard + 0.9% additional).
The semi good news is if you’re self-employed, the employer Medicare rate stops at 1.45% and is exempt from the additional 0.9% even if you make more than these thresholds. The bad news is these income amounts aren’t being adjusted for inflation, so more and more people are getting subject to the additional 0.9% every year.
- $250,000 for married taxpayers who file jointly.
- $125,000 for married taxpayers who file separately.
- $200,000 for single and all other taxpayers.
Related: The Best Time To Take Social Security
The Positives Of Higher Payroll Taxes
It’s important to always look at the bright side of higher Social Security and Medicare taxes.
1) The more taxes we pay in, the higher the chance we’ll actually receive the full amount of Social Security and Medicare promised to us. Hopefully most of us have already completely written off any sort of Social Security benefits by the time we reach our 60s and 70s. It’s always good to have low expectations of government promises.
2) We insure that more working people pitch in to pay for our great country. It’s very hard to avoid payroll taxes. Yes, if you do the math, 173 million workers who will pay payroll taxes equals only 54% of the estimated 319 million people in the United States. But 54% of the nation paying taxes is better than a sharp stick in the eye! The other 46% of the population are too young, too sick, too poor, too unwilling, or too old.
3) The government controls more people by making them afraid of becoming free thinkers who are independently wealthy. Why do you think the first thing Chairman Mao and Fidel Castro did when they got into power was confiscate land from the wealthy and send them to farm?
Having to pay 7.65% in payroll taxes as a laborer is already painful. To pay 15.3% in payroll taxes as an entrepreneur is oppressive. The less people realize the massive upside of being an entrepreneur, the less people will threaten government.
4) Higher taxes encourage people to make a whole lot more than $132,900 to get a “bargain” on every incremental dollar earned. The tax cuts that went into effect in 2018 have practically abolished the marriage penalty tax, eliminated the top 39.6% tax bracket, and raised the income threshold for the highest 37% marginal tax rate. The only problem is that SALT deductions have been limited to $10,000, which is a blow to expensive coastal city inhabitants.
Ways To Counteract Higher Payroll Taxes
Now that you realize Social Security is kind of a rip off, you should understand the income types not subject to Social Security tax. This way, you can save money.
If you’re stuck in the rat race, there’s really no way around paying Social Security and Medicare taxes. If you’re earning close to the maximum income of $142,800 subjected to Social Security taxes, it’s not like you’re going to tell your boss to give you a pay cut.
Instead, you’re going to continue kissing butt in hopes of getting that amazing 3% pay raise next year just so you can afford to pay for the tax hike!
If you’re self-employed, you’ve got more flexibility. You could choose to pay yourself a lower wage and give yourself more in distributions, which aren’t subject to payroll taxes. For example, let’s say you brought home $200,000 in operating profits (revenue – operating expenses) before taxes.
You could theoretically pay yourself $30,000 in wages and give yourself a $170,000 distribution so you’re only paying $4,590 in Social Security and Medicare taxes ($30,000 X 15.3%) versus taking home $200,000 in wages and $0 in distributions and having to pay $15,772.80 SS ($127,200 X 12.4%) + $5,800 Medicare ($200,000 X 2.9%) = $21,572.80. That’s a huge $16,982.80 in tax savings!
If the $200,000 entrepreneur was a W2 employee instead of being self-employed, his/her tax bill would be $7,886.4 SS ($132,900 X 6.2%) + $2,900 Medicare ($200,000 X 1.45%) = $11,40. So it’s hard to call $16,982.80 a complete “savings.”
The risk of paying only 15% of your operating profits as a salary is that you might get audited. How much an entrepreneur with an S-Corp can pay himself in income and distributions is a gray area. I’ve argued for a ratio of no greater than 50/50.
Finally, the absolute best way to counteract ever-rising payroll taxes is to simply earn income that is NOT subject to payroll taxes! What types of income are not subject to payroll taxes? Here’s a list.
Investment Income Not Subject To Payroll Taxes
Here are the Income Types Not Subject To Social Security Tax:
- Dividend income
- Rental income
- Venture debt income
- Private equity income
- P2P income
- CD interest income
- Capital gains
- Student income, ministerial income, exempt wage income
- Real estate crowdsourcing income – I’ve personally invested $810,000 in real estate crowdfunding to invest in lower valuation, higher net rental yield properties across the heartland of America. There is a multi-decade trend of workers and companies moving away from the expensive coasts thanks to technology and the rise of remote work.
What’s also good about investment income is that you may get some tax breaks on income and capital gains. The tax rate on long-term (more than one year) gains is 15%, except for high-income taxpayers ($400,000 for singles, $450,000 for married couples) who must pay 20%. High-rate taxpayers will typically pay the healthcare surtax as well, for an all-in rate of 23.8%.
Qualified dividends have a tax rate of 15%. Meanwhile, there are no federal taxes due on income produced by municipal bonds. For those who invest in their own state’s municipal bonds, there isn’t state income tax due either.
Knowing the government will never efficiently manage other people’s money, I started building a passive income portfolio in 2000 so I could have more of my money back. As soon as you can make enough passive income to cover all your living expenses, you are not only free to do whatever you want, you’re also free of the 7.65% payroll tax for employees and 15.3% payroll tax for the self-employed!
Wealth Is More Important Than Income
Because the government is always going after income, wealth is much more important for financial freedom. For example, you could be worth $10,000,000 and not have to pay payroll taxes or income taxes since you can live off your investments.
You could also partake in subsidized healthcare under the Affordable Care Act. Further, your kids could get 100% of their college tuition paid for by universities given they determine grants by income and not by wealth.
The more you work, the more you have to pay in taxes. Instead, work smarter by focusing on building more investment income or equity in a business, especially as corporate taxes are getting cut. You can build wealth up to $11.4 million as an individual or $22.8 million as a married couple before the estate tax kicks in.
From now on, really think about how all your income sources are taxed. Do you really want to work all day for the privilege of paying federal income tax, state income tax, city income tax, Social Security tax, Medicare tax, and so forth? Just like inflation, tax increases will never end.
Earn More Passive Income Through Real Estate
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. Real estate income is very tax efficient due to non-cash depreciation expense. Further, you can sell real estate and earn up to $250,000 / $500,000 in tax-free profits if you are single or married.
In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms. With interest rates down, the value of cash flow is up. Further, the pandemic has made working from home more common.
Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the way to go.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio.
Updated for 2022 and beyond. Income Types Not Subject To Social Security Tax is a Financial Samurai original post.
Husband and wife are flipping houses. What deductions for income tax can we claim? Can we claim our own labor for the work we have done in the house?
Thomas Schmidt says
suppose instead of working for an S-Corp, you work for a C-Corp. there are any number of executives (Steve Jobs was one) who paid themselves $1 a year. So all the work you do becomes corporate profits instead of wages. Under the new tax law, that means you pay 21% Federal taxes.
As I recall, the first 90k or so of dividend payments are tax free for married low-income workers. If you lived in an income-tax-Free State, this would mean that, on corporate income of about $115,000, you’d pay the Feds about 24k in total taxes. Run some numbers through TurboTax and check it.
Pros should look up Subchapter T.
dan f says
A bill being considered before the House Ways & Means committee right now proposes to hike the social security tax significantly by (1) increasing the total burden from 12.4% to 14.8% and (2) subjecting high earner wages to the SS tax for all wages in excess of $400,000. The second one will put a lot more pressure on the meaning of “reasonable compensation” when using the S-Corp tax savings strategy!
When my S corp’s earnings were growing quickly, I had to figure out the magic annual salary where individual 401k employee and employer’s were maxed out relative to employee and employer social security “contributions.” That annual salary was $60,000. I was previously paying myself $160k and contributing $40k to a SEP IRA. With $60k, I could contribute $15k as an employee and $15k as an employer. I believe the wages cap was $92,000 at that time. It would be interesting to re-do that analysis now with a higher cap.