Questions about retirement income taxes confuse many taxpayers, especially when the topic is specific to Social Security and other pension-related income. After all, the taxpayer has watched those deductions be subtracted for many years. He expects to finally enjoy watching money flow back in during retirement, right? Well, not so fast. Retirement income is subject to income taxes, including FICA.
FICA is the tax deducted from payroll per the Federal Insurance Contributions Act, passed in 1935. It imposes a payroll tax on salaries and other wages (paid by employees and employers) to fund Social Security and Medicare benefits. The portion that supports Social Security is financed by a 12.4 percent tax on earnings up to a 2022 maximum of $147,000. Employees and employers each pay 6.2 percent, while self-employed individuals bear the entire 12.4 percent levy. The Medicare tax rate is 1.45% for employees and employers, but there is no maximum wage limit. As with Social Security, self-employed taxpayers are responsible for the full 2.9 percent of Medicare contributions. Highly compensated individuals also pay an additional 0.9 percent for Medicare on amounts over $200,000 for single taxpayers or $250,000 for married taxpayers filing jointly.
Suppose you start a business after retiring. If you earn income from your business, you will pay taxes on it, including FICA. In fact, most likely, you will pay the self-employed "double-dip" amount of 12.4 percent for Social Security and 2.9 percent for Medicare, plus the added 0.9 percent for Medicare on earnings above the threshold. On the other hand, if you get a regular job, you will still pay FICA, but only the normal employee portion.
If you had a deferred compensation plan before you retired so that your employer set aside a certain amount of your annual salary, you did not pay income taxes or FICA deductions on that amount. However, you will owe taxes when you receive the deferred amounts (presumably after retirement). So, while your income tax bracket may be lower than when you worked for your full salary, the FICA rate will remain the same.
You may not pay FICA taxes if your retirement income isn't from wages or businesses. If you receive Social Security benefits, you may owe income taxes, depending on the amount you receive and your overall tax circumstances. However, Social Security payments aren’t subject to FICA. Other retirement income may also be excluded. For example, interest, dividends, pension payments, and annuity distributions are excluded from FICA deductions.
If you take distributions from retirement accounts like a 401(k) or IRA, you already paid FICA taxes when you earned the money. So, even though contributions to these tax-deferred accounts are exempt from your taxable income, you still pay FICA amounts when you defer. That's why your W-2 has a box for wages and one for FICA wages. So, in retirement, when you withdraw from these accounts, the amounts are tax-free, including any growth or matching contributions from your employer.