5 Things to Know About the Payroll Tax -Cut Extension

How does this tax break apply to you?

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When Congress agreed to extend the payroll tax cut on December 23, it created an important holiday gift for 160 million workers. Here are five things to help you understand how this tax break applies to you.

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1. The extension is temporary. For 2011, workers enjoyed a 2 percentage-point reduction in their Social Security taxes. Instead of paying 6.2 percent on earnings up to the annual wage base ($106,800 in 2011), they paid only 4.2 percent. This rate had been set to run only through the end of 2011, but Congress extended it for two more months. Thus, the rate applies through Feb. 29, 2012, on earnings up to the annual wage base of $110,100 in 2012.

Congress likely will extend the rate reduction for the balance of the year. However, nothing is certain from Washington until a bill is signed into law by the President.

2. The extension also applies to self-employed individuals. The rate cut is not limited to employees. It applies as well to the employee portion of the Social Security tax that is part of self-employment tax, which is paid by self-employed individuals. The tax rate for the employer portion of the self-employment tax remains unchanged.

Self-employed individuals are allowed to deduct the employer portion of the tax as an adjustment to their gross income. Before 2011, they deducted 50 percent of their self-employment tax, which was the employer portion. However, because of the rate reduction that began in 2011, the deduction is more complicated; it reflects the employer portion of the tax, which works out to more than 50 percent of the self-employment tax.

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3. The rate reduction is automatic. To enjoy the rate reduction, employees don’t have to do a thing. The employer will take it into account in figuring the withholding for Social Security tax.

Because Congress acted so late in the year, many employers and payroll services may not have had time to implement the change at the start of the year. The IRS says that employers should put into effect the new payroll tax rate as soon as possible in 2012, but not later than January 31, 2012. If an employer did not implement the change immediately, then any Social Security tax over-withheld from a paycheck during January will be refunded to the employee. Employers are instructed to make an offsetting adjustment in workers’ pay as soon as possible but not later than March 31, 2012.

4. The reduction has no impact on your Social Security benefits. Even though workers are paying less tax into the Social Security system, they do not suffer any reduction in the benefits that will ultimately be collected. The federal government promises to pay the benefit that would otherwise have been received. The benefits are figured on the basis of earnings (up to the wage base limit for the year) and not on the taxes paid.

5. Higher-income earners are subject to a new recapture tax. Those who earn more than 1/6th of the wage base limit in the first two months of 2012, or $18,350 ($110,100 times 1/6) face a new recapture rule when they file their 2012 income tax return in 2013. The 2 percentage-point reduction applies to their actual earnings during the extension period, but any tax on earnings in excess of this amount will be included as an additional income tax on the 2012 return.

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For example, say someone earns $12,000 per month ($144,000 for the year). This means that earnings in the two-month period will exceed the $18,350 cap by $5,650 ($24,000 - $18,350). This person must include $113 (2 percent of $5,650) as an additional income tax on the 2012 return.

In conclusion, enjoy your tax savings while you can. If the economy continues to improve, it is unlikely that the payroll cut will be extended beyond 2012. Also remember that there is no reduction in the Medicare tax, which remains at 1.45 percent for employees and 2 percent for self-employed individuals. If you have any questions about how the tax change affects you, consult a tax advisor.

Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser’s 1001 Deductions and Tax Breaks and The Complete Idiot’s Guide to Starting a Home-Based Business. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at www.barbaraweltman.com and host of Build Your Business radio. Follow her on Twitter @BarbaraWeltman.