Sifting through Social Security information and understanding how the system works can be confusing. When you add the subject of taxes into the mix, heads can begin to spin. Getting familiar with common terminology can help you navigate the ins and outs of Social Security deductions.
Pretax and post-tax deductions
The most common payroll deductions are likely savings plan contributions and group insurance premiums. Deductions such as traditional 401(k) contributions and health plan premiums are typically not subject to payroll tax. In that case, these benefits fall under the category of pretax deductions. The amounts are subtracted from gross pay before taxes are calculated and, therefore, lower the employee’s tax liability. Conversely, contributions to a Roth 401(k) plan is taken from after-tax money, known as a post-tax deduction, having no bearing on taxable income. Both pretax and post-tax deductions reflect voluntary benefits whereas Social Security tax is withheld by Payroll under federal law.
Social Security wages
The Federal Insurance Contributions Act (FICA) mandates the collection of Social Security tax. The Social Security tax that Payroll withholds is based on a percentage of the line item shown on your W-2 Form as Social Security wages, which equates to gross pay minus deductions not subject to Social Security tax. The amount of Social Security wages is the basis of your benefit determination.
Pretax deductions that reduce Social Security wages include Section 125 cafeteria plan amounts. This refers to medical insurance, dental insurance and flexible spending accounts. While the traditional 401(k) is a pretax deduction for income tax purposes, this does not reduce Social Security wages.
Social Security taxes
In 2020, the FICA tax imposed on employees is 6.2% of Social Security wages. The employer must contribute an equal amount. Self-employed individuals are required to pay the entire 12.4% tax. Each year, the law establishes a cap on taxable earnings. As posted on ssa.gov, “For 2020, the maximum amount of taxable earnings is $137,700.” So for this year, no Social Security tax is withheld once an employee’s income exceeds $137,700. Note that there is no comparable cap pertaining to Medicare taxes. Since 1994, all earnings are taxed for Medicare.
Tax on monthly benefits
There are several factors that may impact a beneficiary’s tax liability once payments from the Social Security Administration begin. These variables include income level, tax filing status and state of residence. When first applying for benefits, the applicant may request monthly withholding. Current beneficiaries who wish to change or cease withholding need to complete Form W-4V, which can be obtained from the Internal Revenue Service. Consult with your personal accountant to identify the best approach for your tax situation.
Taxing Social Security Administration benefits is determined on the state level. As of 2020, there are 13 states that impose a tax, each with their own computation method: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia.
Visit the Social Security Administration website for benefit planners and links to publications, such as “Tax Guide for Seniors,” and “Social Security and Equivalent Railroad Retirement Benefits.”