If you saw an increase in your paychecks late last year, don't fall into the myth of believing it was free money arriving out of thin air. It was actually the result of a payroll tax deferral that was put into effect on Sept. 1 in order to provide some stimulus to the economy. But that extra money you took home was more of a loan than a gift, and it likely will impact the taxes you pay in 2021.
How payroll taxes work
In August, President Trump issued an order allowing employers to defer payroll taxes for employees from Sept. 1 through Dec. 31, so if your employer participated, your paychecks during that period would have been larger by the 6.2% that is normally deducted in Social Security taxes. You would, however, have continued to see deductions for the other payroll taxes listed below.
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But again -- Trump's payroll tax postponement was not a "get out of tax free" pass for anyone. Workers will still have to pay those Social Security taxes at a later date.
Here are the most common types of payroll taxes (excluding state taxes):
| Payroll Taxes | Paid by Employer | Paid by Employee |
|---|---|---|
| Social Security tax | 6.2% up to wage base | 6.2% up to wage base |
| Medicare tax | 1.45% (additional tax for higher earners) | 1.45% (additional tax for higher earners) |
| Federal income taxes | None (withheld from employee's wages) | Withheld from wages |
| Federal unemployment taxes | 6% of eligible wages, up to $7,000 | None |
Here's how Social Security tax works. Let's say you are paid $3,000 every two weeks. Multiply the $3,000 by 6.2%, and you've calculated your biweekly Social Security tax liability: $186. That amount is deducted from your paycheck to fund benefits for current retirees. Your employer will pay the other $186 portion of the Social Security tax directly to the IRS. So Trump's payroll tax postponement would have allowed your employer to put an extra $186 into your pocket every two weeks.
A closer look at the payroll tax holiday
Here's the tricky part: Those who benefited from the deferral will now get slammed with higher tax withholdings starting in January to make up for all the taxes they didn't pay during the previous four months. If you were one of them, your take-home pay could shrink by 6.2% from where it was before the "tax holiday," and stay squeezed until the end of April.
Employers have the responsibility of collecting these payroll taxes. If they don't, they'll be hit with penalties, interest, and other taxes.
Were your payroll taxes deferred?
To have been eligible for the payroll tax postponement, your biweekly wages must have been less than $4,000. If you earned a salary instead, your annual earnings must have been less than $104,000.
If you're not sure whether your company was giving you these payroll tax loans, you can ask human resources or take a look at your paychecks to get your answer. The combined Social Security and Medicare taxes make up the Federal Insurance Contributions Act (FICA) tax rate on your pay stub. That's usually 7.65% of your gross pay (up to the Social Security wage base of $137,700 in 2020). Some companies may list Medicare tax on a separate line; in that case, FICA only consists of the 6.2% Social Security tax.
Take a look at how much of your gross pay was taken out in FICA taxes. If your employer was deferring Social Security taxes for you, the amount of money deducted from your checks under that line would only have been 1.45% of your gross pay.
Planning ahead
Now that you know that your paycheck could possibly shrink in 2021, you can prepare; you'll want to make sure you have enough cash on hand to handle all your financial responsibilities.
Another concern to consider is the potential impact those tax deferrals could have on your 2020 federal taxes. The boost in income could have pushed you into another tax bracket. Since workers who made less than $4,000 biweekly were eligible for the payroll tax deferral, an employee could have taken home as much as an additional $496 per month in their paychecks during the last four months of 2020. If that tipped you into a new marginal tax bracket, each dollar of income that exceeds the lower bracket's threshold will be taxed at a higher rate.
But don't let the government's payroll tax sleight of hand sour your mood. Knowledge is power, and now that you understand how those temporary tax deferrals really worked, you'll be able to make plans to compensate for how they'll affect your finances in the months ahead.
