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.

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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.