Over the last few weeks we’ve produced numerous commentaries and examples regarding the personal income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. provisions in the stimulus bill. One of the cornerstones of Obama’s tax plan is the new Making Work Pay credit. While a majority of workers will be eligible for this credit, it may not be clear to everyone what exactly the credit is or who is eligible.
Before we discuss the credit it would probably be helpful to review payroll taxes. Payroll taxes pay for Social Security, Medicare, and unemployment insurance. Currently, federal payroll taxes consist of a 12.4 percent Social Security tax, and a 2.9 percent Medicare tax, for a total of 15.3%. Every employer is required to withhold half of this payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. , or 7.65%, from their employees’ paychecks. The employer is required to pay the other half themselves. Unlike income taxes, which many people can reduce to zero (or less) through use of the tax code’s myriad exemptions, deductions and credits, everyone who earns an income pays payroll taxes.
The employee portion of the Social Security tax is 6.2% (half of the total 12.4% Social Security tax). This tax rate is the starting point for the Making Work Pay credit. The credit equals 6.2% of earnings up to a maximum credit of $400 ($800 for a married couple), so that the maximum credit amount is reached when earnings reach about $6500 ($13,000 for a couple). The credit stays at this maximum $400 value until adjusted gross income reaches $75,000 ($150,000 for a couple). At that point the credit begins to “phase out,” meaning that its value is gradually reduced until it reaches zero for adjusted gross incomes over $95,000 ($190,000 for a couple).
Although the credit is administered through the income tax system, it is designed to provide Social Security tax relief by offsetting the Social Security tax liability on the first $6500 of an individual’s wages. While you must have wage or salary income to be eligible for the credit, it is refundable, which means that even lower income workers who have little or no income tax liability can benefit from the credit in the form of a refund.
The IRS has recently released new income tax withholding tables for 2009 which will require employers to reduce their employees’ withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. to reflect the new credit. The plan is that starting on April 1 wage earners will see a small increase in their after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income. on their paychecks for the rest of the year. The $400 credit spread out between April and the end of the year comes out to about $10 per week in extra cash. The change is automatic, so workers will not have to file a new W-4 to receive the new credit.
It is important to note that while the new credit is designed to offset some of a taxpayer’s Social Security tax liability, the savings are actually coming via the income tax code, not a cut in the Social Security portion of the payroll tax. The credit works by reducing in income tax withholding in order to offset part of your payroll tax withholding. One might ask why lawmakers don’t just change Social Security taxes. One reason is that Social Security taxes are linked to Social Security benefits and cannot be changed without changing the benefits calculation. If lawmakers wanted to reduce Social Security taxes they would probably be required by law to reduce Social Security benefits, which would be a politically difficult task.Share