What The Payroll Tax Deferral Means For Your Budget

Effective Sept. 1, many Americans — including military members — may have noticed a 6.2% increase in their paychecks. The increase was the result of an Executive Memorandum issued in August, creating an optional deferral of certain payroll tax obligations through the end of the year.

While the goal is to provide temporary relief during the COVID-19 pandemic, the outcome may have unintended consequences for unprepared individuals.

Before you knock off your shopping wish list or sign a lease on your new dream car, understand that this is just a pay advance, explains USAA advice director and CERTIFIED FINANCIAL PLANNER^TM professional Mikel Van Cleve. “You have to pay it back next year.”

Because the payroll tax, which funds Social Security, by law must be collected by May 1, 2021, individuals will be responsible for paying that money back in the first quarter of next year.

Will my paycheck be affected?

Servicemembers with monthly basic pay of less than $8,666.66 will participate, according to the Defense Finance Accounting Service (DFAS). “For context, an O-5 with more than 14 years of service has basic pay of $8,486,” explains Van Cleve. “This means a vast majority of servicemembers will participate.”

Participating servicemembers will see a temporary 6.2% increase on each paycheck from now until the end of the year, but they should prepare to see a decrease in January. The normal 6.2% withholding will return plus the repayment of the payroll tax not withheld from Sept. 1 to Dec. 31, 2020. This new decreased net pay level could continue through at least April 2021 and is expected to return to normal in May. 

Civilians who work for participating employers will be subject to the same tax deferment and repayment schedule: Civilians with earnings less than $4,000 in any biweekly pay period will notice a temporary 6.2% increase in their paycheck until 2021, when it will likely decrease until at least April 30, 2021 to pay back the taxes.  

Typically, the payroll tax is listed as “FICA” on your paystub or Leave and Earnings Statement (LES). To see the increase associated with a temporary 6.2% boost, check a previous month’s paystub or LES.

While participating employers, including the federal government and Department of Defense, are still working out the details on the collection process per the IRS implementation guidance, participating employers must withhold and pay the deferred taxes between January 1 and April 30, 2021. If any taxes are not repaid in that period, interest and penalties will begin to accrue on May 1, 2021.

“That means it’s likely the repayment will take place during the first four months of 2021 via 'doubling the payroll tax' to 12.4%,” says Van Cleve.

Note that if you separate from your employer in 2020 before the payroll tax can be collected in 2021, you are still responsible for the repayment of that tax.

How should I prepare?

Because there’s still uncertainty surrounding how the tax will be repaid, Van Cleve warns against increasing your lifestyle expenses or spending the money on a big purchase. 

Instead, look at your budget to determine how best to allocate the extra money in your paycheck.

“The key is to remember that this extra money is temporary,” says Van Cleve. With that in mind, he suggests making two budgets: one for now, which reflects your 6.2% increase, and one for January, which reflects your 12.4% decrease.

Take a look at the second budget, which should reflect your lower take-home pay. Do you have enough money to cover all your expenses? Have you fully stocked your emergency fund with three to six months’ worth of living expenses? “If you answered yes to both questions, then you could consider using the additional money now, as you see fit,” Van Cleve says. “If you’ve accrued credit card debt, you may want to use the additional money to pay down some debt.”

If next year’s budget allows you to cover all your expenses, think about how you want to tweak your current budget to account for the additional income, whether that’s paying down debt or saving for a short- or long-term goal.

But if next year’s budget looks tight, consider adding a savings bucket in your current budget where you can sock away the extra money in your paycheck. Then when January rolls around, you can use that money to cover any shortfalls.

“Especially if you’re living paycheck to paycheck, as many people are, a double-digit decrease in your take-home pay can really set you back,” says Van Cleve.  “At USAA, it’s our mission to facilitate the financial security of our members, and one of the best ways we can do that is to help you prepare for the future.”

For help with creating or reviewing your budget, consider using the free USAA My Budget tool on usaa.com.

As additional information is released, consult the IRS  and DFAS for the latest news and updates.

USAA believes the websites and resources used to gather this are reliable; however, we cannot guarantee the accuracy or timeliness of the information.

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