Question

If Kathie Barnes earns \(\$ 50,000\) and Katie Harvey earns \(\$ 500,000\) a year, they both will pay Social Security tax _____. a) at the same average tax rate b) but Kathie Barnes will pay at a higher average tax rate c) but Katie Harvey will pay at a higher average tax rate d) but it is impossible to tell what their average tax rates are

Short answer

b) but Kathie Barnes will pay at a higher average tax rate.

Step-by-step solution

Determine the Social Security tax rate

The Social Security tax rate for employees is 6.2% of their income.

Calculate the taxable income for Social Security tax

There is a cap on the taxable income for Social Security tax purposes. In our case, let's assume the cap is at \(\$ 142,800\). Therefore, any income above this amount is not subject to the Social Security tax.

Calculate the Social Security tax for each individual

For Kathie Barnes, since her income of \(\$50,000\) is below the cap, her entire income is subject to the Social Security tax: Kathie's Social Security tax = \(0.062 * 50,000 = \$3,100\) For Katie Harvey, only the first \(\$142,800\) of her \(\$500,000\) income is subject to the Social Security tax: Katie's Social Security tax = \(0.062 * 142,800 = \$8,853.6\)

Calculate the average tax rate for each individual

The average tax rate for each individual can be calculated by dividing their Social Security tax by their income: Kathie's average tax rate = \(\dfrac{3,100}{50,000} * 100 = 6.2\% \) Katie's average tax rate = \(\dfrac{8,853.6}{500,000} * 100 \approx 1.77\% \)

Compare the average tax rates

Comparing the average tax rates, we can see that Kathie Barnes has a higher average tax rate (6.2%) compared to Katie Harvey (1.77%). The correct answer to this problem is: b) but Kathie Barnes will pay at a higher average tax rate.

Key concepts

Taxable Income Calculation

Understanding how to calculate taxable income is essential for grasping the nuances of tax obligations. Taxable income is the portion of your income that is subject to tax after all deductions and exemptions are applied. For Social Security tax specifically, there is a concept of a wage base limit or cap.

This means that only income up to a certain threshold is considered in calculating the tax. For example, if the cap is set at \(142,800\), then any income earned above that limit will not be taxed for Social Security purposes. This cap can change yearly and is determined by the government. It's a critical figure for the taxpayers who earn above the cap, as they would not owe additional Social Security tax beyond this point.

Average Tax Rate

The average tax rate is a useful indicator of the portion of income that goes towards paying taxes. It is calculated by dividing the total taxes paid by the total taxable income and is commonly expressed as a percentage. The average tax rate can provide a broader view of the tax burden on an individual or entity.

For instance, a person with a lower income might pay a more significant percentage of that income as Social Security tax compared to someone with a higher income, especially if they exceed the Social Security tax cap. In the provided example, Kathie Barnes, who earns \(50,000\), pays an average tax rate of 6.2\%, whereas Katie Harvey, with her \(500,000\) income, pays a reduced rate of around 1.77\%. This demonstrates how the wage base limit can lead to a lesser average tax rate for high-income earners.

Social Security Tax Rate

The Social Security tax rate is a fixed rate that is applied to income to support the U.S. Social Security program, which provides retirement, disability, and survivorship benefits. As of the knowledge cutoff in 2023, this rate is typically 6.2% for employees, which is matched by their employers, totaling 12.4% contributed towards Social Security.

However, as discussed in the taxable income calculation, there's a limit to how much income is subject to this tax. It's critical to recognize that the tax rate is the same for all earning below the cap, which implies that despite differing income levels, employees contribute at this uniform rate up to the wage base limit. Consequently, those earning above the cap, like Katie Harvey in the exercise, stop paying this tax after their income surpasses the threshold, hence the contrasting average tax rates observed when compared to lower earners like Kathie Barnes.