Why Is There a Cap on the FICA Tax?

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Why Is There a Cap on the FICA Tax?

The Federal Insurance Contributions Act (FICA) levy is made up of Social Security and Medicare. In 2021 and 2022, FICA taxes will total 15.3% of salaries. It is divided into 12.4% of earned income up to an annual maximum that must be paid into Social Security and 2.9% that must be paid into Medicare.

There is no income restriction (or wage base limit) for the Medicare share of the tax, which means you must pay half of the 2.9% tax on all earnings received for the year, regardless of how much money you make. However, the Social Security tax has a wage-based limit, which implies that there is a maximum wage that is subject to the tax for that year, after which there are no more taxes to pay.

So, why is this the case? And what are the benefits and drawbacks of the FICA cap?

Key Takeaways

  • The Federal Insurance Contributions Act (FICA) tax is collected on Social Security and Medicare payroll withholding.
  • Income tax restrictions do not apply to Medicare taxes, although there is a wage-based limit on Social Security taxes.
  • The restriction restricts the amount of Social Security taxes that high earners must pay each year.
  • Income tax limitations, critics contend, unjustly benefit affluent incomes over poor ones.
  • Others say that lifting the ceiling would result in one of the greatest tax increases in history.

How FICA Taxes Work

But first, a short refresher of how FICA works. Essentially, every U.S. taxpayer with earned income is required to pay it.

  How Is Social Security Tax Calculated?

If you’re a waged or salaried employee, you’ve definitely seen the FICA boxes in the payroll tax area on your paystubs and yearly W-4 statements. The amounts represent your share of the FICA tax. Half of the tax—6.2% for Social Security and 1.45% for Medicare—is automatically deducted from each paycheck, and the other half is contributed by your employer.

However, if you are self-employed, you must pay the whole sum (12.4% for Social Security + 2.9% for Medicare, for a total of 15.3%). However, on your federal income tax return, you may normally deduct half of the FICA tax. This applies to any self-employed individual who earns more than $400 per year who reports on and files IRS Form 1040 Schedule SE.

Understanding Income Caps

Whatever your job status, you’ll notice that the two forms of FICA taxes have distinct restrictions. Income tax limitations do not apply to Medicare taxes, but Social Security taxes have a wage-based restriction, which means they do not apply to wages over a specific level. This sum is increased yearly to account for inflation.

The salary base limit for Social Security taxes in 2021 is $142,800, up from $137,700 in 2020. That implies that regardless of how much you make, you may have up to $8,853.60 (6.2%) withheld from your paycheck for Social Security taxes for the year.

$147,000

In 2022, the maximum annual earnings due to Social Security withholding are $9,114, for a total tax of $9,114.

When President Roosevelt submitted his Social Security concept to Congress in early 1935, there was no income restriction. The initial proposal exempted high incomes from Social Security entirely, including both taxes and benefits, and anybody earning more than $3,000 per year was planned to be fully excluded from the system.

  Effective Tax Rate Definition

The exemption for high earnings was withdrawn as FDR’s proposal moved through Congress, and the House Ways and Means Committee replaced it with a $3,000 ceiling. Historians have uncovered no evidence that explains why the committee selected an earnings ceiling over an exception, but it has remained in effect since. Since 1982, it has increased at the same pace as the economy’s earnings.

Advantages and Disadvantages of Income Caps

The wage ceiling subject to tax has been a source of contention. It implies that, although the ordinary worker pays tax on every dollar of income (the overwhelming majority earn less than the wage base limit), the top earners pay tax on just a portion of their earnings. Critics believe that FICA tax ceilings are unjust because they impose a greater cost on people earning less, a regressive tax structure that contradicts the American progressive income tax system.

Of course, there’s the presumption that lower-wage people are the primary beneficiaries of Social Security (as opposed to the rich, who are thought to have more savings and hence need less benefits)—part of the original justification for imposing the income restriction in the first place.

Furthermore, some individuals feel that raising the ceiling would generate considerable cash, which might assist fill the gap that Social Security would soon face: The Old-Age and Survivors Insurance (OASI) Trust Fund (which provides retirement payments) will only be able to pay planned payouts on time until 2033 as of 2021. After that, it will only be able to pay 76% of benefits.

  Is Social Security Taxable?

Raising or removing the taxable wage ceiling would undoubtedly make a difference. The Office of the Chief Actuary (OCACT) of the Social Security Administration estimates that gradually increasing the taxable maximum (for both contributions and benefits bases) to cover 90% of covered earnings over the next decade would eliminate roughly one-fifth of the program’s long-term shortfall. According to OCACT’s estimations, if all earnings were subject to the payroll tax but the current-law base was used for benefit calculations, the Social Security trust funds would be sustainable for more than 40 years.

The Bottom Line

Any modification of the FICA cap system is fraught with difficulties. It would be a method to supplement Social Security. Having separate bases for contributions and benefits, on the other hand, would undermine the historic relationship between the taxes employees pay into the system and the benefits they get.

Nonetheless, given the significance of the Social Security system to American employees, caps will undoubtedly remain a topic of discussion for some time.

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