If you've ever wondered how important Social Security is to the financial well-being of our country, here's a fact to take to heart: Each month, roughly 64 million people receive a benefit check. Of these 64 million, more than a third (22.1 million) are being pulled above the federal poverty line solely because of this guaranteed monthly payout.
It takes a lot to fund a program that divvies out 64 million checks a month, and Social Security's 12.4% payroll tax on earned income does much of the heavy lifting. Although Social Security has three sources of income -- the payroll tax on earned income, interest income on its asset reserves, and the taxation of benefits -- it's the payroll tax that was responsible for bringing in $885 billion of the $1 trillion the program collected in 2018.
Yet, you might be surprised to learn that more than $1.2 trillion in earnings "escaped" the payroll tax in 2016. In fact, the amount of earnings not subject to the payroll tax has grown from a little over $300 billion in 1983 to $1.2 trillion by 2016. The fact is that not every source of income is taxable by Social Security's payroll tax, and it certainly pays to know which column your income might fall into.
With that being said, here are eight sources of income that Social Security's payroll tax won't be able to touch.
1. Exempt wage income
One of the more controversial aspects of the payroll tax is that it's only applicable to wage and salary income between $0.01 and $132,900, as of 2019, with this earnings cap rising to $137,700 in 2020. Every earned dollar above this cap is exempt from the 12.4% payroll tax. What this means is that while roughly 94% of working Americans are paying into Social Security on every dollar they earn, about 6% of the work force earning more than $132,900 (in 2019) will have some of their wages or salary exempted from the tax.
If you're curious why this cap exists in the first place, it has to do with the Social Security Administration also capping monthly benefits paid at full retirement age.
2. Dividend income
The stock market's plain-as-day secret is that dividend stocks and the regular income they provide are the key to rapid long-term wealth creation. Dividend stocks have historically run circles around their non-dividend-paying peers, and payouts can be reinvested via a dividend reinvestment plan. But one added bonus you may not be aware of is that dividend income doesn't fall into the "earned income" column. This means if you're raking in substantial income from dividends, you won't have to worry about being hit with Social Security's payroll tax on these payouts.
3. CD interest income
Chances are that investor interest in certificates of deposit (CD) from banks has waned considerably this decade as yields have shrunk. Nevertheless, CDs provide some of the safest sources of income in the country, albeit with those aforementioned low yields. The good news here is that the interest income earned on CDs is exempt from Social Security's payroll tax. Note, however, that you could still owe tax at the federal or state level on the CD interest income you earn.
4. Bond income
Speaking of safe forms of income, the interest income earned from bonds ranks right up there next to CDs as being among the safest ways to nominally increase your principal investment. Similar to dividend and CD interest income, bond income won't be subjected to the payroll tax. And as an added bonus, some types of bonds are also exempted from federal and/or state tax.
Generally speaking, municipal bonds purchased in the state in which you reside are often exempt from any taxation, making them a popular choice for ultra-conservative investors.
5. Capital gains
According to national pollster Gallup, 55% of Americans surveyed in September owned publicly traded stock(s). If investors decide at any point to sell their stocks and lock in their profits, they'll be recognizing a capital gain. While capital gains are dealt with very differently at the federal level depending upon the length of time you've held onto a stock, as well as what income tax bracket you fall into, one thing for certain is that capital gains aren't classified as earned income. That means all capital gains will be exempt from the payroll tax.
6. Rental Income
While most of the exemptions from Social Security's payroll tax thus far have been pretty straightforward, this one comes with a bit of an asterisk. You see, if you meet the definition of a real estate professional, whereby you perform at least 750 hours a year in real estate property trades or businesses, then your income is subject to the payroll tax. But if you're the casual property owner who simply rents out one (or more) properties to generate added rental income, then you're in the clear and will not have to pay into Social Security on the rental income you receive.
7. Ministerial income
Although pinpointing the number of religious congregations in the U.S. is difficult, the Hartford Institute believes there are about 350,000. That's a lot of potential church ministers who could be completely exempted from Social Security's payroll tax.
In general, as long as a minister is ordained, commissioned, or licensed by a church or church denomination, their earnings won't be considered "earned income," although most ministers will still be subject to the self-employment tax.
8. Student income
Last but not least, college students who get a job with their university can completely avoid being hit with Social Security payroll tax. Students will still have to demonstrate that they're enrolled in college and attending class in order to qualify for this benefit, but for students, it's a nice perk that'll allow them to hang onto more of their income.