What The Payroll Tax Deferral Really Means for Your Paycheck
The IRS has been busy keeping up with changes last year between the income tax deadline extension to July 15th, 2020 and the stimulus checks.
On August 8th, 2020, President Trump added another change that the IRS had to account for. On this date, President Trump issued an executive order deferring specific payroll tax collections.
This helps give these taxpayers more money in their pockets today. It may not end up helping in the long run, though.
Here’s what you need to know.
What Does the Executive Order Say?
The executive order is a memorandum for the Secretary of the Treasury.
It orders the Secretary of the Treasury to defer the withholding, deposit and payment of certain payroll taxes. It also states the deferral will not result in penalties, interest, additional amount or addition to the tax.
In particular, it targets the 6.2% Social Security tax that is withheld from your paychecks. In 2020, the 6.2% tax is owed on the first $137,700 of eligible wages.
It does not apply to the Medicare payroll taxes. Additionally, the executive order doesn’t defer any of the employer’s portion of Social Security or Medicare taxes.
The executive order is in effect from September 1, 2020 through December 31, 2020. It is only available for people that generally earn less than $4,000 per bi-weekly pay period.
A deferral, not tax forgiveness
The key here:
This is a deferral.
It doesn’t forgive the tax owed. You’re going to have to pay it back.
The President’s executive order further asks the Secretary of the Treasury to explore ways to eliminate the obligation to pay the tax amount that is being deferred.
This isn’t likely to happen unless Congress passes a law allowing it. If they do, the amount may be forgiven. Don’t count on it, though.
While the President’s executive order guides the Treasury to defer the payroll tax, it doesn’t go into detail on all aspects of how it will work.
The IRS has issued its own guidance that dives deeper into the subject.
The executive order doesn’t say when the deferred taxes will actually be due. The IRS’s memorandum states the deferral postpones the due date until January 1, 2021 through April 30, 2021.
The IRS also states how the deferred taxes should be collected.
The deferred taxes must be withheld from compensation on a ratable basis from January 1, 2021 through April 30, 2021 to make up for the amount reduced from the deferral.
The IRS guidance states that arrangements can be made outside of this general guidance to collect the total taxes owed from the employee.
This could become an issue if an employee leaves a company before April 30, 2021. Your last paycheck may be significantly reduced to repay the amount that will be due next year.
Any taxes due that are outstanding on May 1, 2021 begin accruing interest, penalties and additions to tax.
What This Means for Your Paycheck
So what does this mean when it comes to your paycheck?
You need to find out if your employer is participating in the payroll tax deferral.
Your employer may have sent out an email or memo stating whether they’re participating or not. If they haven’t communicated with you, check your paycheck to see if the payroll tax withholding has decreased.
Those that aren’t sure can contact their payroll department or human resources department to ask directly.
Smaller companies may not have these departments. In these cases, ask whoever usually runs payroll each week.
If your employer is participating, you should see your paycheck increase through the end of 2020.
Your paycheck will only increase if you make less than $4,000 per bi-weekly pay period. This equates to roughly $104,000 per year.
If your employer is not participating, your paycheck will remain the same assuming nothing else changes.
What Should You Do If Your Company Is Participating?
If your employer is participating, the first thing you should do is understand how this impacts you.
Until the end of 2020, your paycheck will be bigger as long as you make less than $4,000 per bi-weekly pay period. This seems like a good thing.
The bad news:
You’re going to have to start paying the Social Security tax again normally in 2021.
To make the news worse, you have to pay back the deferred amount, too.
This means your 2021 paychecks will be smaller than your average paycheck prior to the deferral taking place.
So what should you do with that extra money in your paycheck? You can technically do whatever you want with it. It’s your money.
That said, there are a few smart money moves you may want to consider.
Set money aside
The most responsible thing to do is to set the extra money aside.
Since your paychecks will be smaller in 2021 to pay the tax deferral back, saving the money sets you up for future success.
When you get hit with a smaller paycheck in 2021, your budget won’t get shocked.
Instead, you can take the money you set aside to make up for the shortfall.
Add to your emergency fund
If you don’t live paycheck to paycheck and the extra payback won’t hurt you, you may want to add to your emergency fund.
By putting the money in your emergency fund, it’s still saved in case you need it at the beginning of 2021.
If you can cover the extra taxes in 2021 without dipping into your emergency fund, you’re in even better shape.
A larger emergency fund puts yourself in a better overall position for future financial shocks.
Pay down debt
Paying down debt may be another option.
For this to work, you should be able to absorb the smaller paycheck in 2021 without it being a financial strain.
If you can, you may be able to save interest by making extra principal payments early with the extra money you’re getting now.
Paying off the principal reduces the interest you owe and speeds up the debt pay off process in most cases.
An exception exists for loans with precomputed interest. These usually require you to pay the full interest due whether you pay the loan off early or not.
When your lower paycheck comes in 2021, you can reduce your extra payments. You still need to make the minimum payments due, though.
Overall, you’ll come out ahead the majority of the time as long as you don’t miss any payments. This happens because your principal balance is reduced earlier, reducing the interest owed in the future.
Invest for the long-term
Those with a stocked emergency fund and no debt may choose to add this money to their long-term investments.
No one can predict what will happen with investment prices in the next few months.
However, investing earlier gives you more shares today if investment prices gradually rise over the next year.
If Your Company Isn’t Participating
If your company isn’t participating in the payroll tax deferral, there isn’t much you can do.
This may seem like a bummer now because your paycheck isn’t going to increase.
The good news is your paycheck isn’t going to take a double hit in 2021. Your paycheck won’t shrink because you never got a boost in the first place. You also don’t have to pay any deferred amount back.
For people living paycheck to paycheck, having an employer not participate could be a blessing in disguise.
President Trump initially wanted a legitimate payroll tax cut included in a stimulus bill to boost Americans’ paychecks.
When that didn’t happen, he issued an executive order aimed to give household relief from the coronavirus pandemic’s financial strain.
It does this by deferring the employee’s portion of Social Security tax through the end of the year rather than cutting the payroll tax.
Unfortunately, the order only defers the Social Security payroll tax due. It doesn’t forgive it.
That means you’ll have to pay it back starting in January 2021 through the end of April 2021.
Congress may choose to forgive this amount in the future, but it is unlikely.
For those living paycheck to paycheck, the deferral may seem helpful. Unfortunately, your paycheck will be reduced to a lower than average level in 2021 to pay the taxes back.
If your finances are tight, set the extra payroll tax deferral money in your paycheck aside. Don’t touch it.
When your paycheck shrinks in 2021, start using the money you set aside to cover your expenses. You’ll be glad you were prepared when it happens.