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On Aug. 8, amid congressional gridlock, President Donald Trump issued a series of executive orders designed to improve the financial circumstances of Americans who are suffering in the wake of the COVID-19 pandemic. Chief among these orders is the proposed payroll tax holiday.
Under the order, American workers making less than $104,000 annually wouldn’t have to pay their share of the payroll tax for the rest of the year beginning Sept. 1. If you fall into that category, you would be getting bigger paychecks as we approach the end of the year. Think of it as another round of stimulus from the federal government that provides more short-term pandemic relief.
There’s one caveat here, and it’s a big one: Trump’s executive order represents a deferral payroll taxes. It doesn’t wipe them out for good. So, should the executive order be enacted and nothing else changes, taxpayers might end up stuck with a pretty sizable tax bill in 2021 and 2022 (currently, half of the deferred taxes are due by Dec. 31, 2021, with the other half due by Dec. 31, 2022).
That said, President Trump has directed Treasury Secretary Steven Mnuchin to see whether there’s a way to forgive the deferred payroll taxes permanently. Trump has also hinted the deferred taxes won’t need to be repaid if he’s reelected.
Before we examine the potential impact a payroll tax cut would have on taxpayers and small businesses, let’s take a step back with a brief primer on payroll and income taxes to get a clearer picture of what we’re talking about.
What is the payroll tax?
Payroll taxes are taxes that are automatically withheld from employees’ paychecks and are set aside to fund federal social insurance programs like Social Security and Medicare.
If you’re a W2 employee and you’ve studied your paystubs, you’re probably familiar with these acronyms — FICA, the Social Security tax, and MEDFICA, the Medicare tax. At the time of this writing, taxpayers fork over 6.2 percent of their income to FICA and 1.45 percent of their income to MEDFICA.
In other words, your payroll tax rate is 7.65 percent, which your employer matches. If you’re self-employed, you’re responsible for both the employee and employer share of payroll taxes, which add up to 15.3 percent.
While the payroll tax applies evenly to all workers, it doesn’t apply to salaries over $137,700 for the 2020 tax year (this “taxable maximum” changes every year). So, if you were to make $150,000 in 2020, the payroll tax wouldn’t apply to the last $12,300 of your income.
Finally, some employees might be subject to an additional 0.9 percent Medicare tax if they make enough money ($250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for single taxpayers).
What is income tax?
Income tax is a tax imposed on your salary by federal, state, and sometimes local governments. This is generally the moneymaker for governments, with the bulk of their revenue coming from income taxes.
Unlike payroll taxes which are earmarked for specific expenditures, income taxes are used more generally on things like public services, military, debt, and other projects and initiatives. Also unlike payroll taxes, income taxes are progressive. The more money you make, the higher your income tax rate will be. There are seven tax brackets for 2020, with the lowest earners paying 10 percent of their income and the highest earners ($518,401 or more for single taxpayers and $622,051 for married taxpayers filing jointly) paying 37 percent.
Currently, there are seven states that don’t impose any income taxes on workers: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire and Tennessee don’t tax wages right now, but they do tax investment income and interest. And while most cities and counties don’t tax income, there are nearly 5,000 jurisdictions across the United States that do.
How are payroll tax and income tax different?
If you’re a W2 employee, payroll taxes and income taxes will likely be deducted from every paycheck you receive. So, in the sense that your check will be lower than you’d hope it would be, payroll taxes and income taxes are quite similar.
Still, there are a couple of very distinct differences between the two types of taxes, which we’ll briefly examine now.
1. Fixed rates vs. progressive rates
While payroll taxes are implemented at the fixed rate of 7.65 percent (with your employer matching that 7.65 percent, for a grand total of 15.3 percent of your salary), income taxes change depending on how much money you earn each year.
In 2020, the income taxes brackets for single taxpayers are as follows:
- 10 percent on income up to $9,875
- 12 percent on income between $9,875 and $40,125
- 22 percent on income between $40,126 and $85,525
- 24 percent on income between $85,526 and $163,300
- 32 percent on income between $163,301 and $207,350
- 35 percent on income between $207,351 and $518,400
- 37 percent on income above $518,401
2. Fixed caps vs. brackets
While payroll taxes “shut off” after $137,700 (aside from that extra 0.9 percent Medicare surcharge for high earners), there’s no similar threshold for income taxes.
If you made $100 billion in income this year, you’d be taxed at 37 percent — the same rate you’d be taxed at if you made $519,000.
3. Employer contributions
Each pay period, the income tax comes entirely out of your paycheck and the money you’ve earned. Employers, however, pay half of your payroll tax obligation, which is 7.65 percent in 2020.
Of course, if you’re self-employed, you get the “best of both worlds,” so to speak, by being responsible for both the employer and the employee’s share of payroll taxes.
4. Specific purpose vs. general purpose
Your payroll taxes — and the employer’s matching share — go toward funding specific programs like Medicare and Social Security. Income taxes are sent directly to the governing body’s general fund and can be used to finance a variety of different programs and initiatives.
At this point, you have a solid understanding of payroll taxes, income taxes, how they’re different, and how the White House is currently working to defer payroll taxes for the last four months of the year. Next, we’ll explore the impact this payroll tax holiday might have on your wallet.
What Trump’s payroll tax holiday means for businesses and taxpayers
Under the Coronavirus Aid, Relief and Economic Security Act (CARES Act) — more broadly known as the coronavirus relief package — employers that met certain thresholds by keeping workers on payroll qualified for payroll tax benefits.
In May, President Trump expressed his hope to deliver a similar benefit to employees: “I want to see a payroll tax cut on both sides, a very strong one, because that’s going to really put people to work.”
While workers would ostensibly welcome this temporary financial relief, Trump’s proposal has received mixed reviews, at best, from folks in Washington, D.C.
Some pundits have lauded the proposal while others say it doesn’t go far enough and still others have speculated as to whether the order is even legal. In addition to drawing the ire of Democrats and their presumptive nominee, Joe Biden, Republican Senator Ben Sasse, who represents Nebraska, also called the payroll tax holiday “unconstitutional.”
President Barack Obama “did not have the power to unilaterally rewrite immigration law with DACA, and President Trump does not have the power to unilaterally rewrite the payroll tax law,” Sen. Sasse said in a statement. “Under the Constitution, that power belongs to the American people acting through their members of Congress.”
It remains to be seen what will happen to this proposal in the coming weeks. An analysis by the Institute of Taxation and Economic Policy, however, found that — assuming it goes through as it appears — $139.5 billion wouldn’t be set aside for Medicare or Social Security for the remainder of the year. This could pose a problem for both programs, the trust funds of which are both underfunded.
In any case, here are some things to keep in mind as we continue to see how the proposed payroll tax holiday plays out:
- If you make more than $4,000 every two weeks, this doesn’t apply to you — unless you’re an employer.
- If you do qualify for the relief, there’s a good chance you will have to pay the deferred taxes back in 2021 and 2022, or at least a portion of them. So, if you find yourself receiving bigger paychecks, you may want to stash some of those funds so you can repay your obligation without as much of a headache in the future.
- The median worker stands to end up with an additional $75 each week under Trump’s order.
- It’s not yet clear how the president’s payroll tax holiday proposal would impact self-employed individuals and contractors.
- Per the executive order, employers don’t have to give payroll taxes to their employees; they just don’t have to send them to Washington during the last four months of the year.
- This payroll tax deferral wouldn’t do anything to help the millions of Americans who find themselves unemployed, as well as those who are retired.
Whether you’re an employee or an employer, here’s to increasing take-home pay during the last few months of the year! After what we’ve all been through in 2020, maybe we deserve a little more cash in our pockets as we move closer to next year.