What is Earned Income?

In 2014, 131.8 million or roughly 90% of the US workforce generated their primary income as an employee. Employment is a wonderful and rightfully celebrated accomplishment for an individual and family, usually providing benefits in addition to compensation such as health insurance, retirement savings options, paid time off, etc. However, employment is also one of the most expensive tax transactions there is. Allow me to show you why.

Two Types of Taxes

Every dollar of income you earn from your employer is subject to income tax. You are likely familiar with how the income tax system works, but if not, I wrote a brief breakdown HERE. In addition to the income tax rates, which can be as high as 37% in 2019, earned income is also subject to Social Security tax, Medicare tax, and potentially the Additional Medicare Tax. We can debate whether Social Security is adequately funded to pay your full scheduled benefit when you reach retirement, but one thing is fairly certain, you are not going to get out of paying the taxes today, provided there are a few exceptions for certain types of employees (see section 15). In 2019 Social Security taxes are 6.2% of your first $132,900 of earned income. Every dollar you earn over $132,900 is no longer subject to this 6.2% tax, effectively capping the annual cost at $8,239.80 (2019) per year, per person. The Medicare tax is 1.45% on every dollar of income with no cap. In fact, there is an additional Medicare tax of 0.9% that kicks in on income over $250,000 for married couples or $200,000 for single individuals in 2019. Together, Social Security and Medicare taxes are referred to as payroll taxes.

Bill is a single employee in 2019 and his property taxes, mortgage interest, and charitable contributions do not exceed $12,200. If I had to guess, you are a little surprised that the government takes 22.9% of Bill’s salary every year! There are very few things in personal finance that deal with the magnitude of 22.9% of your annual income. But wait, there’s more. We have only considered one side of the payroll taxes.

Single Individual in 2019

2019 Earned Income:$100,000
Income Tax$15,247
Social Security Tax$6,200
Medicare Tax$1,450
Additional Medicare Tax-
2019 Taxes$22,897

Payroll Taxes: Two Face

Remember that scene (here) in Batman The Dark Knight where Harvey Dent turns his head in the hospital and you see the fire damage on the left side of his face? Even more terrifying than Two Face, the DC Comic character, is the “dual-faced” payroll tax.

In the above example we looked at what Bill paid in taxes was a whopping 22.9% of his salary! In addition, Bill’s employer is also subject to the same payroll taxes of 6.2% Social Security tax on the first $132,900 and 1.45% Medicare tax with no limit. From the eyes of the employer this is a cost of employing Bill. If these taxes were not imposed on Bill’s employer, theoretically Bill would receive this amount as additional compensation. So, Bill is ultimately feeling the effect of an effective tax rate of 30.5%! 

Single Individual in 2019

2019 Earned Income:$100,000
Income Tax$15,247
Social Security Tax (Employee)$6,200
Social Security Tax (Employer)$6,200
Medicare Tax (Employee)$1,450
Medicare Tax (Employer)$1,450
Additional Medicare Tax-
2019 Taxes$30,547

What Can I Do?

Most people would agree that paying 30.5% of their salary in taxes is not the desired outcome, but what can you do about it? Taxes are what they are, right? How am I supposed to pay less than Bill without breaking the law? You might be thinking, I could quit and work for myself, but the self-employment tax works just like the payroll taxes. For a further discussion on self-employment taxes read HERE

There are numerous actions individuals can take to lower their tax bill such as understanding that HSA contributions reduce payroll taxes while 401(k) contributions do not, or restructuring your household income away from earned income, where possible. We do not have the space in this article to go through these available tax saving opportunities, but I have written about many of them HERE.

Conclusion

There are countless ways for individuals to lower their annual tax bill but understanding how to capitalize on those opportunities first comes with understanding the structure on which taxes are assessed. With a basic understanding of payroll taxes, you will be able to better evaluate the tax saving opportunities available to you and your family.