Wage and Salary Income
Taxing Wages and Salary
Employees' labor is typically compensated in the form of wages, salary, and sometimes tips, and that compensation is subject to various taxes at the state and federal levels. At least three federal taxes are imposed on wage and salary income.
Federal Income Tax
The U.S. government imposes income tax on wages and salaries. This is the tax that's calculated on Form 1040, 1040EZ or 1040A each year. The federal income tax rate gradually becomes higher as income rises, and various deductions, exemptions, or tax credits can reduce federal income tax owed.
Federal income tax is deducted from an employee's total compensation in the form of payroll withholding based on the information he provides to his employer on Form W-4. The amount of tax withheld on wages can be more or less than the actual amount of federal tax that's due to the government.
Employees can change the amount of federal income tax deducted from each of their paychecks by adjusting the number of withholding exemptions on Form W-4. This form can be changed at any time during your employment.
Adjusting your withholding will only affect federal and state income tax withholdings, however, not your Social Security and Medicare withholdings.
The Medicare tax is a flat tax on all compensation income. The rate is 2.9 percent as of 2018. Half the Medicare tax or 1.45 percent is paid by the employer. The other 1.45 percent is paid by the employee. Medicare tax is deducted from an employee's total compensation as payroll withholding each pay period.
Social Security Tax
The Social Security tax is also a flat rate tax but this one has a maximum cap. It's 12.4 percent on all compensation income up to a maximum compensation amount of $128,400 in tax year 2018. This cap can be adjusted annually by the Social Security Administration. It's called the Social Security wage base.
Like the Medicare tax, half the Social Security tax is paid by the employer and half by the employee—6.2 percent of the employee's compensation by each.
The Social Security tax rate was reduced to 10.4 percent for 2011 and 2012 only with the employer paying 6.2 percent and employees paying 4.2 percent.
Compensation Exempt from Social Security and Medicare Taxes
A handful of types of compensation are exempt from Social Security and Medicare taxes. They include:
- Reimbursements from the employer to the employee under an accountable plan
- Wages paid to children age 17 or younger employed by their parent
- Medical insurance premiums (both employer-paid and employee-paid)
- Employer contributions to a retirement savings plan
- Contributions to a health savings account
- Long-term sick pay after 6 months since the employee last worked
- Certain types of wages received by students for working through their university or college
- Dependent care benefits up to $5,000 or $2,500 for taxpayers who are married but file separately
- Educational assistance up to $5,250
- Transportation benefits for commuter highway vehicles, transit passes, parking, and bicycle commuting expenses
Overtime, Bonuses and Other Supplemental Wages
Bonuses and overtime are taxed in the same way as wages. Because the payroll withholding tables are graduated based on income, overtime and bonuses can incur higher federal and state income tax withholding compared to your regular pay.
Reporting Wage and Salary Income
There are three reporting mechanisms for wage and salary income. First, employers report your pay and various tax deductions and other payroll deductions on a pay stub, which is issued to the employee at the same time that wages are paid.
Second, the employer will report the total amount of wage income and tax withholding on Form W-2 after the year is over. A copy of the W-2 is also sent to the Social Security Administration and to the IRS.
Third, an employee will report their wage income from all jobs on their annual federal and state tax returns.
State and Local Taxes
Most state governments impose income taxes on wages and salaries in much the same way the federal government does. Some states have a flat tax rate, such as Pennsylvania at 3.07 percent. Other states have graduated tax rates like that of the federal government.
Nine states have no income tax at all on earned income: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. Tennessee and New Hampshire tax only dividends and interest, and Tennessee won't even tax this income after 2021.
Cities and localities throughout the nation impose their own income taxes as well. New York City is perhaps the most famous example of a city income tax. Some local taxes are imposed at the city level such as in Ohio, while other taxes are imposed at the county level such as in Indiana. Still other taxes are set by a school district. This is the case in Iowa.