The Social Security tax was first imposed in 1937 and only applied to employees, not self-employed persons. The initial tax rate was only 1 percent for employees with an additional 1 percent being paid by the employer. In 1951, the Social Security tax was extended to earnings of self-employed individuals.
The Social Security tax only applies to earned income. Earned income includes your wages, salaries, tips, bonuses and other payments for work that you perform. It does not apply to unearned income. If you work as an employee, the Social Security tax is automatically deducted from your paycheck by your employer. Independent contractors and self-employed individuals must make payments to the Internal Revenue Service (IRS) on their own to pay the Social Security tax.
The Social Security tax only applies to a certain amount of income each year. This amount adjusts annually for inflation. Any earned income above the annual limit is not subject to Social Security taxes. For example, for 2010 the limit is $106,800. For 2010, any income earned beyond that amount is not subject to Social Security taxes.
The Social Security tax is split between employers and their employees. As of 2010, the rate equals 12.4 percent, but the employer and employee each pay 6.2 percent. However, because self-employed individuals have no employer, they are responsible for paying the entire Social Security tax themselves. To balance out this extra expense, the IRS allows self-employed individuals to deduct half of their Social Security tax from their taxable income on their income tax returns.
Paying Social Security taxes helps you earn retirement credits that will make you eligible to receive Social Security when you retire. As of 2010, you can earn up to four retirement credits per year and you need at least 40 credits to receive benefits. The more you pay in Social Security taxes, the higher your benefit will be when you retire because your benefit is based on how much you earned during your working career.
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