Five Tax Moves to Make When You Get a Raise

After years of stagnation due to poor economic times, companies are now starting to increase employees’ pay. If you get a raise, congratulations! Here are five actions to take so you can benefit—tax wise—from the increase.

1.     Review your withholding and estimated taxes

More income means more taxes (including additional FICA taxes for Social Security and Medicare). The income tax hike may be more than you think if the raise bumps you into a higher tax bracket. The increase may also transform you into a “high-income taxpayer” subject to additional Medicare taxes and reductions in personal exemptions and itemized deductions. As a result you may have to:

• Adjust your withholding to account for the tax change.
• Start paying or increase estimated taxes. This may be necessary if you don’t want to change your withholding to cover your estimated tax needs (e.g., taxes on net investment income if you’re a high-income taxpayer.

Don’t forget to consider the impact of your raise on state income taxes if you live in a state with such taxes.

2.     Increase retirement plan contributions

Having more money today can help you save for tomorrow. Instead of spending the raise, consider starting or increasing contributions to a company’s retirement plan or your own IRA. Doing so not only creates a nest egg; it may also lower your current tax bill.

Consider whether you’re eligible for the retirement saver’s credit. Eligibility is limited by modified adjusted gross income; see Form 8880. A raise may limit or prevent eligibility for this tax break.

If you’ve maxed out your retirement plan contributions, you can save the new compensation in an after-tax account at a bank, brokerage firm, or mutual fund. Consult an investment advisor to maximize your savings in this account and to coordinate investment selections with those in your tax-deferred (qualified retirement plan) accounts.

3.     Review fringe benefit options

If your employer offers a menu of benefits, a raise may enable you to make selections that you previously couldn’t afford (e.g., life insurance on a spouse, long-term disability coverage). Review your options and, in making choices, factor in the tax results. Some benefits are purchased with pre-tax dollars while others are bought with after-tax dollars. Talk with your company’s benefits department for guidance on your options.

4.     Pay down debt

Paying off outstanding loans is like earning tax-free income. You have more in your pocket but it doesn’t cost you anything from a tax perspective.

However, it may not be wise to pay down a mortgage on your home. This interest is tax deductible and, if you itemize, saves you taxes. Instead, use the funds to pay off credit card debt, car loans, and other borrowing where interest is not tax deductible.

Of course, the decision to pay off mortgage debt is not a tax and financial decision alone. Many prefer the peace of mind in being mortgage free.

5.     Consider making charitable donations

You may want to share your good fortune with others. If you itemize, you can deduct charitable contributions made to IRS-recognized charities. Be sure to check that charities are tax exempt (search the IRS database at http://www.irs.gov/Charities-%26-Non-Profits/Search-for-Charities).

Conclusion

Your additional income can go a long way in increasing your take-home pay, your retirement savings, and your financial well-being. However, you must be proactive in handling the additional funds. It may be helpful to work with a tax advisor to find the best solutions for your situation. And, of course, use some of your new-found money to enjoy yourself; you’ve earned it!