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Understanding the Payroll Tax Cut

1 – Should it be called a Tax Cut?

YES

If we believe the Social Security claim of the last 75 years, what Congress is talking about is reducing the amount of your paycheck that is contributed to the federal Old-Age, Survivors, and Disability Insurance (OASDI) program.  Most people see this as a ‘lock box’, where we are putting away money to be taken out when we retire.  If this were the case then it is really not a tax at all but what you might call a forced savings program.

In reality, Social Security is a pay-as-you-go system, where deductions from employees and payments by employers are used to fund all the Social Security obligations.  Any money not needed is put back into general use by the government in exchange for special government securities that are put into the Social Security Trust Fund.  By 2017 or so the amount collected will no longer cover the expenses and we will have to start ‘redeeming’ some of these securities.  So, in that respect, it is a tax cut.

2 – Will this reduce the benefits you receive when you retire?

NO

To answer this I had to figure out how Social Security benefits are calculated.  Here is the basic math.

You receive “credits” for salary that you receive.  In 2011 you receive one credit for each $1,120 of wages.  The most credits you can receive each year is 4, so by the time you have been paid $4,480 you have maxed out your credits for the year.  You must receive 40 credits to be eligible for Social Security benefits.

Once you are eligible, the Social Security Administration (SSA) looks at 35 years of your salary history.  They take the highest Taxed Social Security earnings that were reported to the IRS on your W-2 each year (which may not be the total amount of your paycheck) add it up and divide by 35.  If you have not worked 35 years then they fill in the missing years with ‘0’.  This number gets divided by 12, reduced by a very complicated formula, and the result is your monthly benefit if you retire at age 67.  So the fact that the SSA takes out less money will not affect this calculation.

3 – Does the cut affect the employer’s contribution?

NO (it didn’t in 2011)

Many people don’t realize that while you ‘contribute’ up to 6.2% of your income into Social Security you employer does the same.  This means that 12.4% of your gross salary (from your employer’s point of view) is going to the SSA, with 1/2 showing up as a deduction on your paycheck and 1/2 being shouldered by your boss.  The portion taken out for Medicare (you and your employer both contribute to this as well) and the portion your employer contributes remains untouched.

4 – Will this cut affect the solvency of Social Security?

Not really

We all know that Social Security is a sinking ship, but this little hit probably won’t make it sink any faster.  The bill includes a “pay for it” provision increasing fees associated with mortgages backed by Fannie Mae and Freddie Mac – but if you read the bill the money collected “… shall be deposited directly into the United States Treasury.”  I don’t see how this helps the SSA.  What is worse, the additional fees are in place through October 1, 2021.  Hurray – Congress has found another way to tax us.

5 – Will the payroll tax cut only last two months?

Probably NO

Two reasons.  First, Congress says they want to extend it for two months so they can fix it when they come back (at the end of January) to last for all of 2012.  Second, there are huge problems for accountants and payroll companies with having a tax rate change for only two months.  All taxes (including payroll taxes) are computed quarterly, and all tax software is set up to handle this three month tax window.  Nobody really knows how to handle a tax rate that changes within the quarter.


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