How the Payroll Tax Expiration Might Affect Your Paycheck

As we near the end of 2012, Congress is on a tight deadline to come to an agreement to avoid a series of tax cut expirations. It has come to be known as the “fiscal cliff” because with $500 billion in tax increases and across-the-board spending cuts, it could ultimately have an impact on your finances.

If Congress makes a last minute deal to prevent us from going off the fiscal cliff, there’s still a chance that the payroll tax break might not be extended. This means that all American workers across all tax brackets could see their take-home pay reduced by 2%. For the average American household, that could result in an increase of $1,000 in taxes in 2013.

Tax holiday was designed to stimulate economy

FICA taxes, designated under the Federal Insurance Contributions Act (FICA), are taken on the first $110,100 of income. It includes a 12.4% tax that is paid into Social Security and another 2.9% that is paid into Medicare. While the self-employed are required to pay all of their FICA taxes, employees split the bill with their employer.

Ordinarily, workers pay 6.2% towards their Social Security contributions. But when the payroll tax holiday was introduced in 2010, that rate temporarily dropped to 4.2%.

The idea was to put more money into the hands of consumers in the hopes of sparking more spending, which in turn would contribute to economic growth. Philip Noftsinger, Business Unit President at CBIZ Payroll, says a reduction in the FICA tax rate was one of the easiest ways for Congress to send money to consumers during the recession.

Some members of Congress believe it has had little positive impact. Some also say it has been taking away funding from the Social Security fund at a time when it needs it the most. By some estimates, that figure could be as much as $150 billion per year.

“It hasn’t had the impact they thought it would and decreasing the input into Social Security at a time when output is rising, isn’t good,” says Noftsinger.

Mari Adam of Adam Financial Associates in Boca Raton, Fla., says no one wants to see their paychecks shrink but Congress, and many Americans, know it’s necessary. Unlike federal income, FICA taxes go directly to entitlement programs for retirement and medical care in your elder years. In many ways, these programs are a form of insurance, which makes the taxes almost a type of insurance premium.

“We’ll all complain but it’s the right thing to do. Social Security is already not on sound financial footing and it’s hard to argue that,” says Adam. “We all need this.”

Impact on paychecks small but noticeable

News about the election and the overall impending fiscal cliff has overshadowed the fact that neither party has expressed an interest in renewing the tax break. Some economists and financial advisors believe there’s little chance it will be extended, so in all likelihood, the employee’s portion of the FICA tax will return to its normal 6.2%.

For an average worker making $45,000 per year, that’s $900 in a year, or $17.30 less they’ll bring home per week. It may not be the end of the world but at a point in time when prices are rising, incomes are already stagnant and investment portfolios aren’t doing that well — every dollar counts.

“It’s not like it’s $100 per paycheck, but it will add up over the course of a year. It’s like a night out per month for a family of four. They’ll notice it,” says Noftsinger.

Because many Americans have become used to that extra money in their pockets, they’re likely going to see it as a tax increase if it hits in 2013. And if they’re not keeping up with the news and current affairs, they’ll feel a little shortchanged when they get their first paycheck in the New Year.

Tom Reahard is CEO of Paycheckcity.com, an online payroll solution, says many employers will likely notify their employees if it’s certain the tax break will not be renewed.

“My guess is this will run down to the last minute but most employers will probably notify their workers at some point,” says Reahard.

Craig Guillot is a business and personal finance writer from New Orleans. He covers insurance, investing, real estate, retirement and debt. His work has appeared in such publications and web sites as Entrepreneur, CNNMoney.com, CNBC.com, Bankrate.com and Investor’s Business Daily. He is the author of “Stuff About Money: No BS Financial Advice for Regular People.“