Types of Taxes You May Incur While Working
Taxes are overwhelming and complicated. I do not believe I have ever met with anyone who says they are fully aware of their taxes and 100% confident in their tax strategy. But with so many moving parts to your taxes, it should be an important part of your financial planning. In this post I will try to simplify the different taxes you may incur during your working years. Taxes in retirement are a whole different story that we will explore in a separate post.
1. Income Tax
Income tax is the most well-known type of tax that workers encounter. It is a tax levied by the federal government, and often by state and local governments, on the income you earn from various sources, including wages, salaries, bonuses, commissions and Restricted Stock Units (RSUs).
Straightforward, right? Perhaps. But did you know that bonuses, commissions and RSUs are considered supplemental income, which is taxed as ordinary income but has a different withholding rate than your recurring paycheck? More on that below.
Federal Income Tax
The federal income tax is progressive, meaning the tax rate increases as your income increases. The U.S. tax system uses tax brackets to determine how much you owe. As of 2024, the federal tax brackets range from 10% to 37%. Here’s a simplified breakdown for single filers:
- 10% on income up to $11,600
- 12% on income from $11,601 to $47,150
- 22% on income from $47,151 to $100,525
- 24% on income from $100,526 to $191,950
- 32% on income from $191,951 to $243,725
- 35% on income from $243,726 to $609,350
- 37% on income above $609,351
State and Local Income Tax
State income tax rates vary widely. Some states, like Texas and Florida, do not levy a state income tax, while others, like California and New York, have some of the highest rates in the country. Additionally, local taxes may be imposed by cities or counties. Maryland, for example, has fairly high local tax rates which varies depending on what county you live in.
Filing and Withholding
Employers typically withhold federal and state/local income taxes from your paycheck based on the information you provide on your W-4 form. This withholding helps spread your tax burden throughout the year and reduces the risk of owing a large sum at tax time.
2. Supplemental Income Tax
Supplemental income tax applies to income that isn’t part of your regular wages or salary. This can include bonuses, commissions, overtime pay, severance pay and Restricted Stock Units. The IRS considers these types of income as “supplemental wages.”
Federal Supplemental Tax Rate
The federal government often applies a different tax withholding rate on supplemental income. As of 2024, the federal withholding rate is 22% if your income is below $1 million and 37% if it is over. However, if your employer does not use supplemental withholding rates, they may withhold tax at your regular income tax rate based on your total earnings.
State Supplemental Tax Rate
States have different rules for taxing supplemental income. Some states may have their own supplemental withholding rate while others may just use the ordinary income tax withholding rate.
Impact on Your Paycheck
Because bonuses and other supplemental wages can be substantial, the tax withheld can significantly impact the amount you receive. Understanding this withholding can help you plan your finances more effectively, especially if you expect significant supplemental income.
3. FICA (Federal Insurance Contributions Act)
FICA is a payroll tax that funds Social Security and Medicare, two critical social insurance programs in the United States. Both employees and employers contribute to FICA taxes.
Social Security Tax
The Social Security tax rate is 6.2% for employees and 6.2% for employers, making a total of 12.4%. As of 2024, this tax applies to the first $168,600 of your earnings. This cap is known as the “wage base limit,” and earnings above this limit are not subject to Social Security tax.
Medicare Tax
The Medicare tax rate is 1.45% for employees and 1.45% for employers, totaling 2.9%. Unlike Social Security, there is no wage base limit for Medicare tax. Additionally, an extra 0.9% Medicare tax applies to earnings over $200,000 for single filers or $250,000 for married couples filing jointly.
Self-Employment and FICA
If you are self-employed, you are responsible for both the employee and employer portions of FICA taxes, resulting in a combined rate of 15.3%. This is often referred to as the self-employment tax. However, self-employed individuals can deduct the employer portion of the FICA tax when calculating their adjusted gross income.
4. Capital Gains Tax
Capital gains tax is levied on the profit you make from selling certain types of investments, such as stocks, bonds, real estate, or other capital assets. The tax rate depends on how long you held the investment before selling it.
Short-Term vs. Long-Term Capital Gains
- Short-Term Capital Gains: These apply to assets held for one year or less. They are taxed at your ordinary income tax rate, which can be as high as 37%.
- Long-Term Capital Gains: These apply to assets held for more than one year. The tax rates for long-term capital gains are generally lower than those for short-term gains and are set at 0%, 15%, or 20%, depending on your income level.
Impact of Income Level
Your total income determines which tax rate applies to your long-term capital gains. Here are the 2024 long-term capital gains tax rates:
- 0% for single filers with income up to $47,025
- 15% for single filers with income between $47,026 and $518,900
- 20% for single filers with income over $518,900
Net Investment Income Tax (NIIT)
High-income earners may also be subject to the Net Investment Income Tax (NIIT). This additional 3.8% tax applies to individuals with modified adjusted gross income over $200,000 (single filers) or $250,000 (married filing jointly). The NIIT applies to your net investment income, which includes capital gains, interest, dividends, and other investment income.
Conclusion
Understanding the different types of taxes you incur while working is essential for effective financial planning and compliance. Income tax, supplemental income tax, FICA, and capital gains tax each have unique rules and rates that can significantly impact your take-home pay and overall financial strategy.
By staying informed about these taxes and how they apply to your earnings, you can make more informed decisions about your finances. Whether you are planning for your next paycheck, a potential bonus, or an investment sale, understanding these tax obligations will help you navigate your financial journey with confidence.