What to Do With a Payroll Tax Cut

Working taxpayers will get a little, temporary raise, if the payroll tax reduction in the tax agreement reached by Congress goes into effect. It’s not life-changing money – the benefit tops out at $2,100 per year for anyone making $106,800 or more – but it is enough to have a ripple effect if used wisely.

Legislators, of course, are hoping you’ll do what Americans usually do with extra cash: buy things, patriotically heating up the economy. In fact, studies show that structuring a tax cut in precisely this way – a little bit over a longer period of time, as opposed to a lump sum – stimulates spending, not saving. Will many people actually stash the extra cash? Probably not, says Ross Eisenbrey, vice president at the Economic Policy Institute, a think tank: “Most people are probably going to spend it.”

But perhaps you’d do better to set your own agenda. Experts say there are ways to use the cash that will turn that 2% raise into a much bigger windfall:

Juice retirement savings

Want an immediate 35% return? Contribute that extra 2% to a 401(k) or a traditional IRA, and someone in the 35% tax bracket would save $560 in taxes. Contributing the money to a Roth IRA would also be a small tax lottery because experts largely expect taxes to rise after 2012 – making today’s after-tax dollars (and therefore, that Roth contribution) “cheaper” than they will be in the future. More convincing: Roth IRA contributions also result in more money come retirement. A 55-year-old who contributes an extra $2,100 in 2011, assuming a conservative 5% return over 10 years will end up with $3,421 – 8.5% more than if he’d contributed to a traditional IRA and paid taxes later.

Create a health-care kitty

The cost of health care is going up next year – an expense most families haven’t yet felt, or budgeted for, but one the payroll tax cut could well cover. Employees are projected to pay about 15% more next year for health insurance deductibles and co-pays, with the average deductible about $675 for a single person and about $1,500 for a family with a preferred provider organization (PPO) health insurance plan. And getting reimbursed for over-the-counter medications like aspirin and cough syrup will be harder next year because they’ll require a doctor’s prescription. From the one-year paycheck increase, a married couple could set aside up to $3,500 of their take-home pay and have enough to cover the health-care-related cost increases, says David Peterson, a certified financial planner.

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