How Wages and Salaries Are Taxed

An employee's labor is typically compensated in the form of wages, salary, and sometimes tips, commissions, fringe benefits, bonuses, and awards. All of this compensation is subject to various taxes at the state and federal levels. At least three federal taxes are imposed on wage and salary income: income tax, Social Security tax, and the Medicare tax.

The Federal Income Tax

The income tax imposed on wages, salaries, and other compensation is calculated on Form 1040 each year. The total amount of your compensation appears in box 1 on Form W-2.

The federal income tax system is progressive—the rates gradually become higher as your income increases, but various deductions and exemptions can reduce the federal income tax owed by reducing the amount of taxable income. Tax credits can be applied to the tax you owe, just as though you had made a payment to the IRS.

Federal Income Tax Withholding

Total income tax withheld from your pay by your employer appears in box 2 of Form W-2. The amount is based on the information you provided on the Form W-4 you would have filled out when you started the job. It might be more or less than the amount of federal tax that will be due to the government when you file your tax return. Your employer remits this money to the IRS on your behalf.

Some of your income might not be subject to withholding. Traditional 401(k) contributions are subtracted first before withholding is calculated, as are some health insurance and group life insurance premiums paid by your employer. Dependent care reimbursement accounts and adoption assistance aren't typically considered taxable income, either.

The Medicare Tax

Adjusting your withholding only affects federal and state income tax withholding, not Social Security and Medicare withholding, because these taxes are applied at a flat rate for all taxpayers. Medicare and Social Security taxes are collectively referred to as "FICA" taxes, named for the Federal Insurance Contributions Act.

The Medicare tax is a flat tax on all compensation income, which is located in box 5 of your W-2. The rate is 2.9%. Half of the Medicare tax, or 1.45%, is paid by the employer. The other 1.45% is paid by the employee. Self-employed individuals are responsible for the full tax of 2.9%. Medicare tax is also deducted from an employee's total compensation as payroll withholding each pay period.

The Social Security Tax

The Social Security tax is also a flat-rate tax of 12.4% on all compensation income up to a wage base set by the Social Security Administration (SSA) each year. Like the Medicare tax, half of the Social Security tax is paid by the employer, and half by the employee—6.2% of the employee's compensation by each.

This tax has a maximum cap—the "wage base"—of $160,200 in the 2023 tax year, up from $147,000 in 2022. The amount that appears in box 3 of your Form W-2 should not be more than $160,200 in the 2023 tax year for this reason. You only have to pay the Social Security tax on compensation and earnings up to this amount.

You could be taxed on more than the year's wage base if you work for more than one employer and they're each withholding Social Security tax up to the base. You can claim a refund from the IRS when you file your tax return if you pay too much, or keep track of your earnings and alert your employers to stop withholding when your total income from all jobs reaches the taxable limit.

Compensation That's Exempt from FICA Taxes

A handful of compensation types are exempt from Social Security and Medicare taxes. They include: 

• Reimbursements from an employer to an employee under an accountable plan
• Wages paid to children age 17 or younger who are employed by their parents
• 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 six 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 $6,000, or $3,000 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 and Other Supplemental Wages

Bonuses and overtime are taxed in the same way wages are. The payroll withholding tables are graduated based on income, so 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 at the same time wages are paid. Not all small employers do that, however. You might have to ask for an accounting by pay period.

Second, the employer will report the total amount of wage income and tax withholding on Form W-2 after the year has ended. 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.

Income That's Not Subject to Federal Tax

Not all forms of income are taxable. Worker's compensation generally isn't, nor are welfare payments. Some qualified pension payments are exempt, particularly for public safety officers, as is child support.

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%. Other states have graduated, progressive tax rates like those of the federal government. 

Some 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 with an income tax. Local taxes are imposed at the city level in Ohio, while other taxes are imposed at the county level, such as in Indiana. Still other taxes are set by school districts, as in Iowa.

Frequently Asked Questions (FAQs)