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What is Payroll Tax Deferral: Everything You Need to Know

| MoneyRates Personal Finance Specialist.
min read

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The payroll tax deferral executive order from President Donald Trump may have stirred up controversy and confusion. Nonetheless, there are ways to benefit from it.

These are the pertinent questions to ask:

  • Does my employer offer payroll tax deferral?
  • Should I opt in?
  • Can I opt out?
  • Do I have to pay the money back?
  • How should I use the money?

The fact is most employees won't be able to defer their payroll taxes. Regardless, you can still take more control over your financial destiny in 2020 and 2021 by creating your own payroll tax deferral. This article can help you learn whether you're eligible and how to improve your situation either way.

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What is Payroll Tax Deferral?

The payroll tax deferral under Section 2302 of the CARES Act, aka the "payroll tax holiday," refers to an executive memo that President Trump released on Aug. 8, 2020. The IRS issued Notice 2020-65 to explain how the order works for taxpayers and employers.

According to the IRS, the "payroll tax deferral" allows employers to defer withholding their employees' portion of Social Security Tax on wages paid for the remainder of 2020. (Medicare taxes, which are 1.45% of gross pay, will continue to be withheld.)

Employees in the plan would receive an extra 6.2% of take-home pay until December 31, 2020. That's $62.50 for every $1,000 in gross pay that you earn.

The deferred tax is not a gift. If you defer payroll taxes, you have to repay those deferred amounts by April 30, 2021.

Are You Eligible for the Payroll Tax Deferral?

Employees who earn less than $4,000 every biweekly pay period are eligible for payroll tax deferral. If you are paid weekly or monthly, your wages are pro-rated to calculate your deferral.

However, the plan is voluntary for employers. Employees cannot force their employers to participate. And in fact, most employers are choosing not to participate in the program. The administrative burden and risk involved isn't something most companies want to take on, especially small businesses.

According to Accounting Today, the most likely reasons for not participating are the changes this would require to their payroll service or processing. They'd have to…

  • ...track who is deferring and the full amount owed.
  • ...collect the repayment in 2021 and pay it themselves - which is risky if employees quit or are laid off before April 30, 2021.

What if You Don't Want to Participate in the Tax Holiday?

There is no official IRS guidance covering whether employees can choose to opt in or out. In practice, participating employers like federal defense agencies are not offering a choice.

"There is no opt-out or opt in-option," says an email sent to employees at the Defense Contracting Management Agency.

"No payroll providers, departments/agencies, nor employees will be able to opt-in/opt-out of the deferral. The Office of Management and Budget and the Office of Personnel Management [and] the Defense Finance and Accounting Service will implement the guidance according to the expectation that all federal civilian payroll providers will act in unison."

The DFAS handles payroll for the Defense Department as well as the Department of Veterans Affairs, Department of Health and Human Services, Energy Department, Executive Office of the President and others.

If you don't need the extra money provided by deferring your payroll taxes, you can at least benefit from it if you're careful.

Direct the extra take-home pay into savings and then use that to repay the tax next year. If you take advantage of the best saving rates available, you can at least earn a small amount to repay yourself for the trouble.

Employer Not Participating? Create Your Own Tax Deferral

What if you could use extra cash now but your employer isn't participating in the tax holiday?

You can simply adjust your own withholding and free up more of your pay right now. Submit a new Form W-4 to your company's payroll department and get a bigger paycheck when you need it now. Think of it as an interest-free tax refund anticipation loan.

However, the same rules apply: You have to pay it back next year, and your deadline is 15 days sooner - April 15, 2021.

Determining the right number of allowances can be tricky. Fortunately, the IRS created this online Tax Withholding Estimator to help you calculate what your tax obligations will be and how much you can safely keep for yourself. If you're getting a refund this year, changing your withholdings can put that money in your pocket now instead of next year.

Repaying Your Payroll Tax Deferral

The total amount you receive through the payroll tax holiday can add up quickly, so don't spend it mindlessly and find yourself in a hole next year.

If you earn $4,000 a month and defer tax between September 1, 2020 and December 31, 2020, you'll owe nearly $1,000 of deferred tax in 2021.

Biweekly Extra Money per CheckTotal Deferral (18 weeks)
$500$31$558
$1,000$62$1,116
$1,500$93$1,674
$2,000$124$2,232
$2,500$155$2,790
$3,000$186$3,348
$3,500$217$3,906
$3,999$248$4,463

The key to successfully managing your deferral is planning.

Because the IRS is not Santa Claus and you will have to repay it, your employer will probably adjust your withholdings next year to cover these amounts so it won't be on the hook for your taxes. But that means you'll be living on smaller checks for the first four months of 2021.

You can make that easier by reducing your debts now, investing in bulk purchases (if you use them) or paring down items you don't really need. Now is a great time to shop and negotiate big-ticket expenses like insurance, consider selling items that you don't use, and create a budget for next year.

Best Uses for the Payroll Tax Deferral

The payroll tax deferral increases take-home pay by $62.50 for every $1,000 of gross income. If you find yourself with extra money, whether you asked for it or not, there are a few good uses to which you can put it:

  • Reduce your account balances
  • Improve your credit rating
  • Take advantage of promotions
  • Make an investment
  • Create an emergency fund

Just remember that you will have to repay the money, so plan to cover all of your tax obligations in 2021.

Reduce your account balances

As noted above, the payroll tax deferral is free money. You pay it back with zero interest. So if you have higher-interest debt on your books, why not use the free money to pay it down?

If your credit card interest is 25% and you owe $1,000, in four months it might rack up over $80 in interest. On the other hand, $1,000 in IRS debt costs nothing as long as you repay it in time.

Eliminating debt now means you won't be paying interest on that debt in the future.

Improve your credit rating

An additional side effect of paying down debts is that your credit score is likely to increase as well. Credit utilization comprises 30% of your credit score, so reducing your debts can probably add a few points to your FICO scores.

However, some credit problems can be cleared up with a little extra cash.

Medical collection accounts, for instance, drop off your credit report and score as soon as they are reported to credit bureaus. Other collections don't work that way automatically. However, you can try to negotiate the removal of a collection in exchange for repayment. It's called "pay for delete." Make sure you get an agreement in writing before sending money.

Take advantage of promotions

How often do you see opportunities to save that you can't quite afford? An app or membership might be $15 a month but $100 per year. The bulk purchase of food could offer you 20% off, for example, if only you had the money. What about flexible offers conveying huge savings for future travel if you could pay for them today?

Make an investment

This strategy isn't for everyone because it can be risky. But the payroll tax holiday is free money. If you can invest it and generate a return greater than zero, you come out ahead. However, if you lose money, you'll need to be able to repay your deferral in 2021 anyway.

You can eliminate the risk by choosing a risk-free investment, although low-risk does equal low return. Check this site to find the best savings account for this venture. Or try a short-term CD or bond, which may offer a higher return than even the best savings accounts.

Create an emergency fund

The coronavirus pandemic has taught us all the value of emergency savings. And in normal times, even $400 can get you out of the most common jams faced by consumers.

A few weeks of extra pay can help you get an emergency savings account off the ground. When you have to repay the money next year, plan in advance, spend less for four months and try to leave the new account untouched.

Payroll tax deferral is the free money that might help you take advantage of savings like these and others.

Take the next step

Even a little extra cash makes a difference to your bottom line. Using it wisely can help amplify the result for a more long-term impact.

Are you working to build wealth or start an emergency fund? Select a financial goal below for saving options and services that could help you further.

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