What Will You Do With Your Two Percent Salary Increase?

Wendy Shick | January 17th, 2011

When Congress passed the Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act of 2010 during the lame duck session late last year, one element of the bill puts more money in the pockets of employees through a one-year cut in Social Security taxes.

The temporary tax cut means employees now pay 4.2 percent instead of 6.2 percent on their first $106,800 in wages. Self-employed individuals will pay 10.4 percent on earnings up to the wage base of $106,800. The payroll tax cut is available to all wage earners regardless of income level.

For a person earning $50,000, the lower Social Security tax will mean an additional $1,000 during 2011.  When you combine the extension of the Bush tax cuts and other measures, the person making $50,000 ends up with a combined savings of $1,890 more for the year than he or she would have paid in 2011 without the new law.

So what will you do with your share?

Increase Retirement Savings. One option is to increase your contribution to your company’s 401(k). You can contribute that additional 2 percent that you’re saving this year on Social Security tax to your pension plan without reducing your net income – you’ll never miss it and save more toward your retirement. Just be sure to check on the other withholding changes that may impact your net pay before you change your contribution.

One additional benefit of increasing your contribution to your workplace retirement plan is that tax is not withheld against that additional 2 percent you’ll put in the 401(k), so your take home pay would still go up in most instances.

Double-check the deadline to make changes to your contributions with your employer, and take advantage of this painless way to increase your savings.

Pay down credit cards. Another option for your additional 2011 pay is to apply your cash toward the monthly payment on your credit card. If you have more than one credit card payment, one method is to apply the extra cash first to the card with the highest annual percentage rate. On the other hand, for those who want to achieve success more quickly, attack a low-balance bill first and eliminate the payment altogether. It will be more gratifying to make progress and may help you stick to a payment plan with other bills.

Pay down your mortgage. Additional payments can help you save the cost of interest over the life of your loan. If you had a 30-year, $250,000 mortgage with a 6 percent interest rate, with a monthly payment of $1,498.88, paying an extra $100 per month from the beginning of your loan, for example, could save you nearly $52,000 in future interest and pay off the loan four and a half years early. On the other hand, if you pay off your mortgage, you’ll no longer receive the benefit of the mortgage interest tax deduction, which can be significant. You’ll want to thoroughly discuss the pros and cons of this option with your tax professional.

Open a Roth IRA. Contributions to a Roth IRA grow absolutely tax-free, and don’t incur taxes upon withdrawal if you wait until retirement to access it. The Roth IRA is especially sweet for a young person. A 25-year-old who contributes $5,000 per year until she retires and makes an average return of 8 percent would have $1.4 million saved by the time she reaches retirement. You can contribute to the Roth only if you have earned income from a job, and if your income reaches a certain level, you won’t be able to contribute any more money to the Roth, but it will continue to earn interest tax-free. Unlike with a 401(k), you can withdraw your contributions (but not earnings, which will trigger a tax and penalty if withdrawn before age 59 1/2/) at any time, tax free and without penalty, and you don’t have to pay it back.

Set up an emergency fund. If you don’t already have an account with at least three to six months of your salary set aside for emergency needs, using the extra cash in your paycheck for this purpose could help you begin to achieve it. Try to make the fund accessible, but don’t make it so easy to access that you spend, rather than save. A money market account in a company across town that isn’t connected to your other accounts might be a good option. Whether the need is an unexpected car repair or a major health problem, having additional money saved will help you have greater peace of mind and be better prepared for life’s little surprises. 

Of course the United States Congress hopes you will use your extra two percent in your paycheck to make purchases and stimulate the economy. Regardless of how you spend the extra dollars in your paycheck this year, having a plan will help ensure that you put the money to the best use for your situation. Be sure to discuss all of your options with your accounting professional.

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