Avoiding The Payroll Tax

If you didn’t read my post on Payroll Tax 101, start there.

If you did, you probably are thinking that payroll tax sucks and that you want to minimize it. Well, contributions to your retirement accounts won’t do it. You might be surprised to hear that contribution to a 401(k) or IRA account does not avoid payroll tax. When you make a contribution to these accounts, it defers Federal tax, but you still owe payroll tax in the year you earn the income.

Oddly enough, if your employer puts money in your 401(k), that does avoid payroll tax. The employer contribution can be either a matching contribution or a direct contribution (some employers just contribute something like 3% of your salary regardless of whether you contribute or not).

For example, if your total compensation is $100,000, the whole $100,000 would be subject to payroll tax regardless of whether you contribute to your 401(k) or not. However, if your employer paid you $80,000 in salary and put the rest into your 401(k), only $80,000 would be subject to payroll tax for you and your employer. Despite the tax benefits, employers are reluctant to do this because they prefer to give each employee the option to control how much they would like to contribute to their 401(k).

One of the ways to avoid payroll tax is by making contributions to your Health Savings Account. Not only does this account have a triple tax benefit of 1) Federal income tax avoided, 2) investment income tax avoided, 3) distributions are tax free, they also avoid payroll tax if the contribution is made directly from your payroll.

Just one more reason why HSAs are awesome and you should max it out every year if you are eligible to open one. It can seriously add up to hundreds or thousands of dollars of tax savings every year.

For more information on HSAs, check out my prior posts here and here.

P.S. Flexible Spending Accounts also avoid payroll tax, but these accounts can be tricky since you have a limited time to use them (usually one year).