Become a better investor
Lesson in Course: Finance at work (beginner, 7min )
We have to pay payroll taxes. Why should I care about payroll taxes and how can I make the most of them?
Franklin D. Roosevelt characterized taxes as “dues that we pay for the privileges of membership in an organized society.” It was with this perspective that he created many lasting government programs under the New Deal during the Great Depression. Today, we still rely on these programs, like Social Security, which are funded by payroll taxes.
Similar to how income tax is withheld for W-2 employees, payroll taxes are a percentage of our pay that is automatically withheld from our paychecks and paid to the Internal Revenue Service (IRS) by our employer on our behalf. The main difference between payroll taxes and income taxes is that payroll taxes fund specific programs while income taxes go into the general budget.
The two biggest programs funded by payroll taxes are Social Security and Medicare. The idea behind how these programs work is that we pay into them today so that we can receive the benefits when we retire or under certain medical circumstances. Social Security provides a source of income while Medicare provides healthcare coverage.
After having paid taxes for the years of working, at age 67, we can start collecting a monthly paycheck from Social Security for an amount based on our life-time contributions. People who paid more over the years will receive a larger check than those who paid less.
We can start collecting social security as early as 62; however, the monthly amount we collect would be 80% of what we would get at 67. We also have the option of working longer and delaying the start of our social security benefits until age 70. For every year that we delay, the monthly amount we get increases by 8%. So waiting until age 70 means we collect 124% of what we would get at age 67!
We need to keep in mind that Social Security is meant to supplement our retirement income, not be something we live off of. There is a growing concern that the funds for Social Security will run out because more people are collecting from it than the number of people paying into it. We are ultimately responsible for how prepared we are for our own future, whether Social Security is there for us or not.
For those of us that work for an employer, we are lucky to share the burden of payroll taxes with our employer. Social Security payroll taxes total 12.4% of our annual salary but we only have to pay 6.2% while our employer pays the other 6.2%. For medicare, we pay 1.45% of our yearly salary while our employer also pays 1.45%, for a total of 2.9%.
If we’re fortunate enough to be earning a higher income, there is a cap to the amount of Social Security tax we have to pay in a given year. In 2020, additional Social Security tax didn't apply to us if we earned more than $137,700, which meant that we were only responsible for Social Security taxes totaling $8,537.40.
We can find out how much we are paying in these taxes by looking at our paystubs. We’ll see Social Security and Medicare under the Federal Insurance Contributions Act (FICA) tax.
For those of us who are self-employed, we are still required to pay these payroll taxes in the form of self-employment taxes. Since we do not have an employer to do this for us, we are responsible for both the employer and employee portions, totaling 15.3%. The 15.3% self-employment tax includes contributions of 12.4% for Social Security and 2.9% for Medicare.
Patience usually pays off when investing and it is true here as well. We all have to pay payroll taxes, but we can get the most out of them if we wait to start collecting at age 70. The 8% increase in the payments each year could be higher than what we could expect from our portfolios at a time in our lives when we shift to safer but lower-returning investments. Life expectancy is going up which means you’ll be drawing on these benefits longer. Waiting to start until we’re 70 can also help lower our tax bill in retirement by making Roth conversions of tax-deferred retirement accounts, or by using distributions from those tax-deferred accounts as income which could eliminate or reduce RMDs and the income taxes of those when we turn 72.