Do You Tax Labor? An Overview of How Work Is Taxed
Understand how your work is taxed. This guide clarifies the different ways income from labor and certain services are subject to taxation.
Understanding how income from work is taxed is a common concern. While labor itself is not directly taxed, earnings from work are taxable. This taxation occurs through various mechanisms, including income taxes on wages and salaries, payroll taxes, and taxes on self-employment earnings. Additionally, certain services may be subject to sales tax, depending on the jurisdiction. This overview clarifies how work-related income is taxed across the United States.
Income Tax on Wages and Salaries
Income earned by employees through wages and salaries is a primary source of taxable income for federal, state, and some local governments. The U.S. federal income tax system is progressive, where higher incomes face higher rates. Tax brackets apply increasing marginal rates to different portions of taxable income, which can range from 10% to 37%.
Taxable income is determined using deductions and credits, which reduce tax liability. Deductions, such as the standard or itemized deductions, reduce the amount of income subject to tax. Credits directly reduce the amount of tax owed. Some credits, like the Earned Income Tax Credit (EITC), are refundable, potentially leading to a refund.
Employers collect income tax from wage earners via withholding. Using Form W-4 information, employers estimate and deduct federal income tax from each paycheck. This money is remitted to the IRS on the employee’s behalf. This system ensures tax obligations are met throughout the year.
Annually, employers issue Form W-2, the Wage and Tax Statement, to employees. This reports total wages, tips, compensation, and withheld federal, state, and local income taxes. Employees use Form W-2 to file their annual federal income tax return, typically Form 1040, by April 15. Withheld amounts on the W-2 are subtracted from total tax due, potentially leading to a refund or additional payment.
Payroll Taxes on Employee Compensation
Employee compensation is also subject to Federal Insurance Contributions Act (FICA) taxes. These fund Social Security and Medicare, federal programs providing retirement, disability, survivor benefits, and healthcare. FICA taxes are distinct from income taxes and withheld from gross pay.
The employee FICA tax rate is 7.65% of gross wages. This includes 6.2% for Social Security and 1.45% for Medicare. Employers pay a matching 7.65%, totaling 15.3% of wages. The employee’s portion is a direct reduction from earnings.
Social Security FICA taxes have a wage base limit. For 2024, earnings up to $168,600 are subject to the 6.2% Social Security tax. Medicare tax has no wage base limit; all covered wages are subject to the 1.45% tax.
An additional 0.9% Medicare tax applies to wages exceeding certain thresholds based on filing status. For single filers, this tax applies to wages over $200,000. Employers withhold this tax once wages surpass the threshold. This tax applies only to the employee’s portion and has no employer match.
Taxation of Self-Employment Earnings
Self-employed individuals, like independent contractors or freelancers, are taxed differently than employees. They are considered both employer and employee for tax purposes. This means they pay both income tax and self-employment tax on net earnings.
Self-employment tax equals the combined employer and employee FICA taxes. The rate is 15.3%: 12.4% for Social Security and 2.9% for Medicare. This tax applies to 92.35% of net self-employment earnings. Like employees, the Social Security portion applies up to the annual wage base limit ($168,600 for 2024). The Medicare portion applies to all net earnings without a limit.
Self-employed individuals can deduct half of their self-employment tax when calculating adjusted gross income. This offsets the burden of paying both employer and employee Social Security and Medicare shares. Like employees, they may also owe the 0.9% additional Medicare tax if net earnings exceed certain thresholds.
Self-employed individuals pay estimated taxes throughout the year, as no employer withholds taxes. These payments, including income and self-employment tax, are usually quarterly via Form 1040-ES. Due dates for calendar-year taxpayers are generally April 15, June 15, September 15 of the current year, and January 15 of the following year. Failing to make sufficient payments can result in penalties.
Sales Tax on Services
Beyond income and payroll taxes, sales tax can apply to services. Historically, sales taxes applied to tangible goods. Many jurisdictions now include certain services. This means service labor may be subject to sales tax, depending on state and local regulations.
Taxable services vary significantly by state. Common taxable services include repair services, like car or home improvement labor. Other examples are landscaping, personal services like grooming, or business consulting. A service taxable in one state may be exempt in another, requiring providers and consumers to understand local rules.
This tax differs from income or payroll taxes; it’s collected by the service provider from the customer at the point of sale. The collected sales tax is remitted by the business to the relevant tax authority. This mechanism broadens the tax base and generates revenue from the growing service sector.