The Social Security system raises the money it needs to provide income to retirees by taxing wage earners. Social Security taxes do not apply to passive income sources or "unearned income," including interest, dividends and capital gains. Instead, Social Security taxes are levied against earned income, which is income gained through active work as an employee or business owner.
Wages and Salaries
Income earned at a job in the form of wages and salaries is subject to Social Security tax. The Social Security tax rate is 4.2 percent for employees in the 2012 tax year, while employers pay 6.2 percent on behalf of their workers. Social Security tax applies to the first $110,100 of earnings for the year; anything above that amount is exempt. Social Security tax on wages and salaries is paid automatically through tax withholding: employers hold back a portion of workers' earnings to pay the tax.
Some workers receive compensation other than wages and salaries. For example, a car sales employee might earn a commission for each car he sells in addition to a normal wage or salary. Similarly, a star employee might receive a bonus in recognition of hard work. Pay that is not included in normal wages and salaries, such as commissions, bonuses, awards, severance and back pay are considered "supplemental wages" that are subject to Social Security tax and normal income taxes.
Employees often receive various forms of non-cash compensation for performing jobs known as fringe benefits. The value of a fringe benefit is generally included in an employee’s wages and subject to Social Security tax. However, certain fringe benefits are exempt from income tax, Social Security tax or both. Benefits that are exempt from Social Security tax include company cars that are used only for business purposes, up to $50,000 of group-term life insurance coverage and retirement planning services.
Self-employed workers, such as small-business owners and independent contractors pay a self-employment tax on net income that includes a tax of 10.4 percent for Social Security. In other words, self-employed workers pay both the employee and employer shares of the Social Security tax. Since self-employed workers aren't subject to tax withholding, they are generally required to pay self-employment tax and income tax by making estimated tax payments to the Internal Revenue Service four times a year. The same earnings cap applies to self-employment income.