Social Security taxes take a big bite out of your paycheck. That's why it's a huge relief to highly paid employees when autumn finally rolls around. Reason: Once they clear the Social Security wage base for the year, they won't need to pay any more Social Security tax for the year.
Strategy: If you're in this boat, don't just pocket the extra money. Add to your 401(k) instead. You won't feel the pinch because your take-home pay will be the same (or more). But you'll be saving thousands of extra dollars for retirement.
Moreover, when you finally withdraw the funds from your 401(k) in retirement, you will probably be in a lower tax bracket. So, you can save income tax on the deal to boot.
Social Security wage base. The so-called FICA tax includes two parts. First: The 6.2 percent Social Security tax applies only to compensation up to an annual wage base ($90,000 for 2005). Second: The 1.45 percent Medicare tax applies to all wages earned during the year.
Once you earn more than the $90,000 wage base—if you haven't done so already—less will be deducted from your paycheck. You don't have to pay the Social Security portion for the rest of the year. If you take most or all of the resulting extra cash flow and transfer it to your 401(k), you can fortify your nest egg without reducing your take-home pay.
Example: Pay yourself, not Uncle Sam
For simplicity, let's say you're in the 28 percent tax bracket and you're paid $10,000 a month. Currently, you're contributing $5,000 a year to a 401(k) where the company matches 50 cents on the dollar.
By October, you will have cleared the Social Security wage base ($10,000 per month times nine months = $90,000). So, each subsequent monthly paycheck will have $620 less deducted in Social Security tax (6.2 percent times $10,000).
Assuming an 8 percent return, your 401(k) will grow to $598,354 after 25 years if you maintain the same level of contributions. But if you contribute the extra $620 in tax savings to your 401(k) this year, your total annual 401(k) contributions will grow to $6,860 ($620 times three months, plus the original $5,000). Then, you follow the same routine for 25 years (for simplicity, we'll assume the contribution amounts stay the same).
When you're ready to retire, your nest egg will be $820,941. That's $222,587 more than you would have accumulated without the extra contributions. And you won't notice any difference in your wallet!