How the Payroll-Tax Hike Can Destroy Your Savings Plan

Saving is hard enough. The payroll tax hike will cost the average worker $700, tempting you to cut saving instead of spending. Look out.

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If you have a job, by now you almost certainly have felt a tax hike that didn’t get a lot of attention during the fiscal-cliff debate: the two-percentage-point increase in the payroll tax.

This tax applies to everyone, not just the wealthy, and it promises to make saving for retirement — or any big ticket — especially challenging. The payroll tax, which funds Social Security and Medicare, is now 6.2% on wages up to $113,700. The tax rate had been at that level until two years ago, when it was cut to 4.2% in an effort to revive the economy.

About 160 million workers pay this tax, and this year’s increase will cost the average worker about $700, according to the Tax Policy Center in Washington. A family with household income of $50,000 will pay about $1,000 in additional tax. This is real money for millions of families.

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Doubtless, many workers will cut their savings in order to maintain their lifestyle. Here’s what that looks like, according to a report in the Wall Street Journal:

A 30-year-old making $50,000 will see his take-home pay shrink $1,000 this year. If instead of cutting spending this worker puts $1,000 less into his 401(k) this year, he could have nearly $12,000 less by retirement at age 66. If he doesn’t increase his savings rate over the next 36 years, the loss to his retirement account could approach $236,000. (And this isn’t even considering any employer matching contributions.)

Looking at it another way, consider two 25-year-olds who start saving 10 years apart — one immediately and the other at age 35. Mutual-fund firm Vanguard calculates that if the early saver stashes away $2,000 a year until age 35 and then saves nothing more, she will accumulate $314,870 by age 65 (based on 8% average annual returns). If the late saver stashes away $2,000 a year for the rest of her working life, she will have just $242,692 at age 65 despite having invested three times as much money.

That’s the power of compounding, and it points up what may be the biggest cause for concern if young people choose to offset this year’s payroll-tax increase with reduced saving as opposed to reduced spending.

The payroll-tax hike will touch Americans in other ways too. Economists say it will shave 0.5% or more off the nation’s growth rate this year, slowing any jobs recovery. Indeed, nearly a third of store managers say shoppers are cutting back on spending because of the payroll-tax increase, according to a survey of shop owners by Merchant Forecast.

(MORE: Cash Leaking out of 401(k) Plans at an Alarming Rate)

The good news is that those cutting back at the mall may be doing so in part to keep their 401(k) contributions at the same level or higher. That’s not an easy decision, but, particularly for young people, it’s probably the right one.

Cutting your expenses doesn’t have to be difficult, especially if you make savings contributions automatic and resolve to live on what’s left. Better to have the payroll-tax increase smart a bit now than to have it damage your finances for the rest of your life.

6 comments
antonmarq
antonmarq

Ha, ha, ha, ha,  ha, ha, ha, ha,  ha, ha, ha, ha, ahhhhhh,  ha, ha, ha, ha,  ha, ha, ha, ha,  ha, ha, ha, ha,.... What savings?

davidjlin
davidjlin

The WSJ quote should have read "$120,000 less," not "$12,000 less," by age 66 - that's assuming 6% average annual compounding of his 401(k).  The $236,000 figure assumes 9% annual compounding.

SamuelClemens
SamuelClemens

Actually this was the sole tax cut that Republicans hated and had to be pushed into accepting. They can't stand anything that helps working people over those who use their money to live off the work of others. Rich people didn't get the 2% cut either which is why the Republicans so very much hated it as a tax cut. This article is factually incorrect and deeply misleading.

The Social Security component is 12.4%, up to the cap after which the rate is 0%. Half of the taxed amount is paid explicitly by the employee and half paid at the same time directly out of payroll funds by the employer but never to be seen by the employee. It is delusional and intentional deception to say that the real rate is 6.2% which is simply the amount listed on the payroll stub. The self employed see the whole thing. A further Medicare portion at the rate of 2.9% is paid uncapped. So the rate is not 6.2% for most people, it is really 15.3% for most people including Social Security, and 2.9% for rich people for Medicare only on generally the smallest potion of their income, if any.

Thus at the current cap the vast majority of working people pay the 2% increase which is really 4% on all of their income. Rich people even when they have a portion of their income that they distastefully must label as earned, such as Mitt Romney's pathetic $350,000 in speakers fees, pay such a small amount on their total income that the effective rate is vanishingly close to zero. The payroll tax is the most regressive and deceitful tax on income in the land. Worse yet, it brings in more revenue than that other one actually labelled "income tax" including the to contributions by the wealthy and the rest of us combined. The wealthy play a sleazy game of taxation. And this latest increase marks a new low: 1% got a 4% increase on a sliver of their income, 90% got a 4% increase on all of their income.

SarahJane
SarahJane

You get what you vote for...

antonmarq
antonmarq

@davidjlin Good luck with that, 6%??? In what time zone, not anywhere in America.