Have you ever noticed that a portion of your paycheck goes toward taxes? It’s no surprise that taxes on earned income include federal income tax, state income tax (in some states), Social Security, and Medicare. These deductions are based on factors like your income level, filing status, and any deductions or credits you qualify for. Understanding how these taxes work can help you confidently manage your finances and plan.

In the U.S., taxes on earned income come in different forms, including federal income taxes, Social Security, and Medicare taxes. If you live in a state with an income tax, you'll also need to account for that and any local taxes.

If you want to know everything about taxes on earned income, including how tax brackets work, Social Security and Medicare taxes, state and local taxes, and how deductions and credits can help lower your tax liability, this guide is for you.

What Is Earned Income and How Is It Taxed?

Earned income is money you receive in exchange for the work you do. This includes your regular wages, salary, tips, bonuses, and other compensation directly tied to your labor. If you're self-employed, the money you earn from your business activities counts as earned income.

Earned income is distinct from unearned income. For example, interest, dividends, rental income, and capital gains are all considered unearned income because they come from investments or assets, not from your labor. While earned income is subject to various taxes, unearned income is generally taxed differently and isn't subject to payroll taxes.

For most people, earned income is the bulk of their income. Therefore, understanding how it is taxed is crucial for tax planning.

Federal Income Tax Brackets: How Much Will You Pay?

The U.S. tax system is progressive, meaning that the more you earn, the higher the percentage of your taxable income. However, it's important to note that not all your income is taxed at the same rate. Instead, income is divided into tax brackets, each taxed at a different rate.

Let's take a closer look at the 2024 federal income tax brackets:

It's easy to get confused by the term marginal tax rate, but understanding it is essential. Your marginal tax rate is the rate at which the last dollar of your income is taxed. However, this doesn't mean all your income is taxed at this rate. Instead, your income is taxed in layers at the appropriate rate for that tax bracket.

Example:

If you're a single filer with a taxable income of $70,000, the first $11,000 will be taxed at 10% ($1,100), the next $33,725 will be taxed at 12% ($4,047), and the remaining $25,275 will be taxed at 22% ($5,561). Your total federal income tax will amount to $10,708.

This progressive system ensures that higher income levels are taxed at higher rates, but only within their respective brackets.

Social Security and Medicare Taxes: Payroll Taxes

In addition to federal income tax, you also pay payroll taxes, which include Social Security and Medicare taxes. These taxes help fund the Social Security and Medicare programs, which benefit retired workers, disabled individuals, and others.

●      Social Security Tax: You pay 6.2% of your earnings up to a sure income cap. In 2024, the cap is $160,200. You won't pay any additional Social Security tax on the excess income if you earn more than this amount. Your employer also pays 6.2%, meaning most workers' total Social Security tax rate is 12.4%.

●      Medicare Tax: You pay 1.45% of all your earnings toward Medicare, with no cap on income. Your employer also contributes 1.45%, meaning the total Medicare tax rate is 2.9%. If your income exceeds $200,000 (single) or $250,000 (married filing jointly), you'll pay an additional 0.9% Medicare tax on those above those thresholds.

Example:

If you earn $70,000:

●      Your Social Security tax is $70,000 × 6.2% = $4,340

●      Your Medicare tax is $70,000 × 1.45% = $1,015

If you're self-employed, you're responsible for the employee and employer portions of these taxes. However, you can deduct half of the Social Security and Medicare taxes you pay from your taxable income.

State and Local Taxes: An Extra Layer of Taxation

While the federal government imposes income taxes, most states also have their income tax systems. The tax rates and brackets vary significantly from state to state, with some states (such as Texas, Florida, and Washington) having no state income tax.

On the other hand, states like California and New York have progressive state income taxes with multiple brackets. For instance:

●      California's state income tax rates range from 1% to 13.3%, depending on income.

●      New York has state tax rates that range from 4% to 10.9% for high earners.

Additionally, cities like New York City and Philadelphia impose local taxes, which can further reduce the amount of your paycheck. New York City residents pay local taxes ranging from 3.078% to 3.876%, depending on income.

Standard and Itemized Deductions: How to Reduce Your Taxable Income

The amount of income you're taxed on is known as your taxable income, and it's calculated by subtracting either the standard deduction or your itemized deductions from your total income.

For 2024, the standard deductions are:

●      $14,600 for single filers

●      $27,700 for married couples filing jointly

●      $21,900 for heads of household

The standard deduction is a fixed amount, but you can choose to itemize deductions if they exceed the standard deduction. Itemized deductions include:

●      Mortgage interest

●      State and local taxes

●      Charitable contributions

●      Medical expenses (if they exceed 7.5% of your adjusted gross income)

Using deductions effectively can lower your taxable income and reduce the amount of taxes you owe. For example, if you have $10,000 in itemized deductions and you're a single filer, your taxable income will be reduced by $10,000.

Tax Credits: Another Way to Lower Your Tax Bill

In addition to deductions, tax credits can directly reduce the amount of tax you owe. Tax credits differ from deductions because they reduce your tax liability dollar for dollar, while deductions only reduce your taxable income. Various tax credits are available for education expenses, child care, energy efficiency, and more.

Planning for Taxes and Financial Independence

Understanding taxes on earned income is essential for planning your financial future. You can adjust your budget and savings strategy by considering how much you owe in taxes—including federal, Social Security, and Medicare taxes. The more you understand the tax system, the better prepared you'll be to minimize your tax liability and maximize your savings.

Use tools like the FIRE Calculator to make it easier to plan for your long-term financial goals. This tool helps you estimate how much you need to save for financial independence and early retirement, factoring in your tax obligations.

For a user-friendly and efficient tool, check out Reachfi.ai, a FIRE calculator designed to provide personalized financial insights and help you stay on track toward achieving your financial independence goals. You can set yourself up for a secure financial future with careful tax planning and savings strategies.

Navigating the landscape of taxes on earned income may appear overwhelming, yet by grasping essential principles and using available tools, you can manage your tax obligations and make wise financial choices. Don't forget to explore deductions, credits, and tax planning resources to enhance your financial strategy and realize your long-term objectives.

References:

1. Internal Revenue Service. (n.d.). Tax brackets and rates. Retrieved from https://www.irs.gov
2. Social Security Administration. (n.d.). Social Security tax cap and contributions. Retrieved from https://www.ssa.gov
3. Centers for Medicare & Medicaid Services. (n.d.). Medicare tax rates and additional Medicare tax. Retrieved from https://www.medicare.gov
4. California Franchise Tax Board. (n.d.). California state income tax rates and brackets. Retrieved from https://www.ftb.ca.gov
5. New York State Department of Taxation and Finance. (n.d.). New York state income tax rates and brackets. Retrieved from https://www.tax.ny.gov
6. New York City Department of Finance. (n.d.). New York City local income taxes. Retrieved from https://www.nyc.gov/finance
7. Tax Foundation. (n.d.). State and local taxes overview. Retrieved from https://www.taxfoundation.org
8. Consumer Financial Protection Bureau. (n.d.). Tax deductions and credits explained. Retrieved from https://www.consumerfinance.gov
9. Intuit TurboTax. (n.d.). Tax filing examples and guides. Retrieved from https://turbotax.intuit.com
10. H&R Block. (n.d.). Tax filing examples and guides. Retrieved from https://www.hrblock.com
11. Investopedia. (n.d.). Tax terms, tax brackets, and planning strategies. Retrieved from https://www.investopedia.com