FICA, which stands for Federal Insurance Contribution Act, is a tax that is paid by employees as well as their employers, and is often referred to as the payroll tax. The purpose of the FICA tax is to fund the Social Security and Medicare programs, which provide benefits to American retirees.
Continue Reading Below
What is FICA?
FICA is the U.S. federal payroll tax, designed to help fund the Social Security and Medicare programs. As of 2017, about 171 million people work and contribute FICA taxes.
Image source: Getty Images.
The basic idea behind FICA is that the current generation of workers is funding these programs for today's retirees, and the next generation will fund the programs for them. The current financial state of both programs isn't quite as solid as it should be (more on that in a bit), but the idea is that the combination of FICA taxes flowing into the programs and the income both programs earn on their reserves should be more than enough to cover all of the promised benefits.
How much are the current FICA tax rates?
There are two parts of FICA -- one for Social Security and another for Medicare -- and both are assessed differently.
- The Social Security tax rate is 6.2% of earned income up to a certain cap. For 2017, the maximum amount of income that can be subject to Social Security tax is $127,200. No Social Security tax is assessed on income in excess of this amount.
- The Medicare tax rate is much lower, at 1.45% of earned income. However, there is no wage cap -- every dollar of earned income is subject to Medicare taxes, even if the income is in the millions. High-income individuals pay an additional Medicare tax as part of the Affordable Care Act as well.
For both of these taxes, employers match their employees' contributions -- for example, the Medicare tax rate is 1.45% each for employers and employees. This brings the total FICA tax rate to 15.3% for earned income up to $127,200 and 2.9% on all income exceeding that threshold. Self-employed individuals are considered to be both the employer and employee, and are therefore responsible for paying both parts of the tax, which is collectively known as the self-employment tax.
What types of income are subject to FICA taxes?
Essentially, any income you earn is subject to FICA taxes. This includes salaries, wages, tips, bonuses, freelance income, and income from a business that you own and actively participate in. FICA taxes are not assessed on passive income, such as dividends, interest, and royalties.
There's a good chance FICA tax rates will change
I mentioned earlier that Social Security and Medicare aren't as financially solid as they should be. You can read thorough discussions of the financial problems facing these programs at these links for Social Security and Medicare, but the general idea is that with the baby boomer generation retiring over the next decade and a half, fewer people will be paying FICA taxes per covered beneficiary than ever before.
As a result, both programs are expected to start running deficits, which will continue for the foreseeable future. Eventually -- in 2034 for Social Security and 2028 for Medicare -- both will be completely out of reserves and will need to make across-the-board benefit cuts.
The exact reform package that will be passed is anyone's guess at this point, but history tells us that something will be done. And one way to enhance the future solvency of both programs would be to increase FICA taxes, either across the board or only for certain people, such as high-income earners.
The point is that while this discussion gives an outline of FICA taxes in 2017, there's a good possibility that these rates, or the Social Security taxable earnings limit, will change in the not-too-distant future.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.