The Pragmatic Planner

Payroll Tax Holiday Farce

About a month ago, I received a text message from a friend with what he thought was good news. President Trump signed an executive order that would provide a payroll tax holiday potentially putting 6.2% of his income back into his pocket.

After a little bit of research into the matter, I had to break the bad news. While the executive order would boost his pay for the remainder of the year, all of that tax would still be due in 2021.

The payroll tax & holiday

Payroll taxes are divided into three main categories: Federal income, Medicare, and Social Security. Trump’s order specifically targets the Social Security tax.

Typically, employees and employers each pay half of the total 12.4% Social Security tax. But under the executive order, employers wouldn’t withhold the 6.2% for Social Security from the employee’s pay. The employer would still contribute their portion.

The payroll tax “holiday,” or suspension period, runs from September 1 through December 31, 2020, and only applies only to those who earn less than $4,000 bi-weekly and less than $104,000 per year.

Some potentially good news is that your employer isn’t required to participate in the payroll tax holiday, which possibly makes the rest of what you are about to read a moot point.

That is unless you work for the Federal government. The U.S. government will implement an across-the-board payroll tax deferral for about 1.3 million federal employees starting in mid-September.

my employer participating, now what?

So what happens if your employer participates in the holiday?

You’ll see an increase in your paycheck over the next few months but come 2021 you are going to have start paying those taxes back and it will roughly double your Social Security tax rate from January 1 to April 30 when they are required to be paid back by.

If you leave employment or just don’t have enough wages to pay it back, the IRS will apply interest and penalties to the amount not paid back which will fall onto your employer to pay. They (the employer) may in turn try to find a way to make you (the employee) pay the interest and penalties. Talk about an uncomfortable situation to be in!

In order to avoid this, I’d suggest setting aside money now (if you can) and then start taking it out to replace the lost wages in January.

Note, there is always a chance that Congress will pass legislation to forgive the deferred taxes but I wouldn’t rely on that.

The True Cost of a New Car

For most Americans, going to a dealership to pick out a new car is a special moment.

Usually, there is a reason behind it — a treat to yourself for getting a promotion, an upgrade for a growing family, or maybe just a mid-life crisis — and the feeling you get when finding “the one” is hard to beat.

But before you give in to your impulsive drive, it’s worth taking a look at the true cost of that new car smell.

First, be careful about framing

Would you rather spend $999 now on the new iPhone XS or only pay $41.99 per month for the next 24 months?

$1,000 out of pocket right now sounds like a lot! But heck $42 per month, that’s just giving up dining out once or twice a month. Easy!

Choosing the subscription-based method seems like it’s easier, but after it’s all said and done, you’ve actually spent more money than if you would have just paid for it upfront.

You need to keep in mind that auto-dealers will play the same framing game, but the numbers are on a much greater scale.

ONly $50 more per month

Let’s say you’ve used an online calculator and found that you could borrow $25,000 for around $466 per month on a 5-year loan at 4.5%, which fits into your budget. Keep in mind the total amount you’ll pay over the life of the loan is $27,964 ($2,964 in interest).

You go to your local dealership to look for cars in the $25,000 price range when a salesperson approaches you and asks, “what are you looking to spend each month?”. To which you reply, “around $450 to $500”.

Now that the salesperson has your “top end”, they begin showing you cars in the $27,000 and $28,000 range and will likely say something to the effect of, “look, you can $3,000 more worth of car for only $50 more per month? Is that really going to break your budget?”.

What they’ve done is shifted your focus away from the overall cost and toward the incremental change that it will have on the payment.

If you borrow $28,000 for 5-years at 4.5%, the monthly payment may only be around $50 more ($522 per month) but you’ll end up paying $3,320 in interest over the life of the loan.

Or just finance for longer

What can be even worse is if you stick to the monthly budgeted amount and the salesperson says, “You can always extend the term of the loan which gets you BELOW your target budget! In fact, you can borrow $29,500 for 6-years at 4.5% and the monthly payment will be around $468 which is right where you want to be at!”.

Quite the compelling story. But what the salesperson forgot to mention is that you’ll end up paying $33,716 over the life of the loan and $4,216 of which is interest. That’s $1,252 more in interest than if you would have stayed with your original amount.

Sadly, it seems like this scenario plays out often.

According to Experian, about 85% of new cars are bought with financing and the average loan term is 69.03 months. Research by R.L. Polk & Co. says that the average length of time drivers keep a new vehicle is 71.4 months — around 6 years.

So what happens at the end of the 6 years? Most people have become so used to having a car payment, they do it all over again!

The tradeoff

What are you really trading off when you continually borrow for a mode of transportation?

I would argue that you are missing out on years of compounding interest and eventually having enough money to spend your time as you please, for however long as that time lasts (AKA retirement).

For fun, let’s pretend that instead of spending $466 per month on a car payment for the next 30 years you contributed that to a Roth IRA. 30 years is the equivalent of owning six cars in your lifetime, which is the average.

Assuming a very conservative annual growth rate of 3%, at the end of 30 years you’ll have accumulated $272,234! Using a slightly higher growth rate of 6% and that amount jumps to $470,444!

Is that new car smell really worth almost half a million dollars?

Roth or Traditional?

An important part of saving for retirement is deciding whether to put money into a Roth retirement account (401(k) or IRA) or a traditional retirement account.

Choosing your retirement savings type wisely could help you avoid paying more taxes than necessary.

Think of yourself as a farmer

A Roth account holds “after-tax” money — or money you have already paid the income taxes on. Its qualified distributions are tax-free: you pay taxes on the seeds, but the harvest, which is hopefully much larger than the initial plating, is tax-free.

A traditional retirement account has pre-tax money: you don’t pay income taxes on the seeds (either by taking a tax deduction or deferring from your paycheck before taxes); you pay the income taxes on the harvest — when you withdraw the money.

When you are making the decision where to invest your retirement savings, consider the following four areas:

Is your tax bracket lower today than your tax bracket will be in retirement?

Anticipating tax rates can be difficult since no one knows how Congress may change tax rates in the future. If you believe you are earning less today than you will in the future (for example, you’re just starting in a career), then a Roth account may be the best option.

On the other hand, if your income is at its peak, a traditional account may be the best option.

Another option is to consider splitting your savings between traditional and Roth depending on your current asset mix (traditional vs. Roth vs. taxable).

Does your employer match your retirement contributions?

If yes, then your employer is already contributing to a traditional 401(k), so consider contributing to the Roth 401(k) to diversify your retirement account types.

Who are your beneficiaries?

If you are leaving money to charities, consider using a traditional retirement account since the charity is exempt from income taxes.

If your children are your beneficiaries, consider whether your children will be in a lower tax bracket after your death than you are now.

Some people choose to give their children the additional gift of prepaying the taxes and leaving the children tax-free money in a Roth account.

Will your required minimum distributions (RMDs) provide more money than you need?

If you already have money saved in a traditional retirement account, the government will require you to take minimum distributions at age 72.

On the other hand, a Roth IRA requires no distributions at a certain age, which means the money can continue to grow tax-free until you need it.

Diversifying your retirement savings between traditional and Roth accounts can be important because during your retirement you can choose to withdraw taxable money from your IRA or tax-free money from your Roth IRA.

Just like a farmer plants different types of seeds, you may want both traditional and Roth retirement funds to choose from when you are retired.

Should I DIY or Pay For A Service?

When it comes to DIY repair jobs and other housework, I always calculate if it makes financial sense for me to actually do it myself or not.

Take for example this paint transfer on my car.

Determine the Cost.

I’ve done my fair share of routine maintenance to my car and figured doing it myself would be a cheaper alternative than taking it to an auto body shop.

It only took me a few minutes of searching on the internet to find exactly what I was looking for, a video tutorial on YouTube.

I began looking around the garage for the things I needed. Luckily, I already had most of the required materials but for illustrative purposes, let’s pretend I didn’t have any of it.

If I had to purchase all of the items for this job, I calculated that it would have cost around $70. The best part is that all of these products can be used over and over.

I predicted that the job would take around an hour. Using the average hourly rate of a personal financial advisor in Indiana, that would be $45 of labor.

After looking at the total estimated cost for me to do the job, which was $115 ($70 + $45), I decided it was worth my time to attempt the repair myself.

I followed the video’s instructions and, as predicted, a little while later I was scuff-free!

The Value of Time and Money.

So what does this have to do with finance? Well, a lot, actually.

Calculating the trade-off of doing a project on your own versus outsourcing the work plays a huge role in making everyday budgeting decisions. And the smarter decisions you make with your time and money, the happier you’ll end up being.

Money Isn’t Everything.

Of course, there are other, non-monetary, factors to consider before deciding to outsource a task or not.

It may not make a lot of economic sense to mow your own lawn, but many people find it therapeutic and enjoy doing it themselves.

Along those same lines, it may not have saved me a lot of money to remove the paint scuff from my car, but I appreciate the challenge of learning a new skill.

Taxation of Alimony

The 2017 Tax Cuts and Jobs Act brought major changes to how alimony payments are taxed.

Under previous law, alimony (also known as maintenance or spousal support) was tax-deductible for the payer and considered taxable income to the receiver.

The new law flipped the structure. For couples divorced after Dec. 31, 2018, payers do not receive a tax deduction for payments and recipients do not have to claim alimony as income.

This is a complete reversal of how alimony has been taxed for decades.

Changes to alimony payments Could Make New Rules Apply

Anyone who finalized their divorce before Dec. 31, 2018, is subject to the previous tax laws when it comes to alimony payments and financial agreements.

But these grandfathered individuals should be cautious if they need to make changes to their spousal support as changes could mean that the new tax rules would apply.

The IRS says that if alimony is modified after December 31, 2018, the new rules apply if the modification:

changes the terms of the alimony payments; AND
states that the alimony payments are not deductible by the payer or includable in the income of the receiver.

If these changes are unavoidable, it’s important to consider the potential tax impact.

For individuals paying the alimony, losing the deduction could increase their taxable income which could disqualify them from contributing to a Roth IRA, cause more of their Social Security payments to be taxed if they are receiving any, Medicare premiums to increase, and more.