Paycheck Leap Year = Retirement Penalty?

    Paycheck Leap Year = Retirement Penalty?

    By Shelly Gigante

    Some employees this year will get an extra paycheck in their pocket, compliments of Leap Year, but those who do could also face a higher tax bill – or a slap on the wrist from Uncle Sam over their retirement account contributions.

    Indeed, the extra pay period in 2016 – the convoluted result of a 366 day calendar year – could push those who fell just shy of a higher tax bracket in prior years over the income line, which would boost their annual tax liability. (Related: Tax Tips)

    Others may find that a minor bump in pay lands them squarely in Alternative Minimum Tax territory. The AMT is a parallel tax system that reduces or rejects many of the most common tax breaks for higher income earners, including the deductions for state and local taxes and interest on home equity loans, if the money was used for anything other than improving a home.

    “Absolutely that could happen,” said Henry Grzes, a certified public accountant and lead technical manager for the American Institute of CPAs, in an interview. “That additional amount of income could clearly put employees in a situation where they would have to concern themselves with a higher bracket.”

    Those who get thrust into a higher tax bracket, he said, would only pay the higher tax rate on the portion of their income that spills over into the higher bracket, due to the progressive tax rate system, but the AMT could be more problematic.  

    “The challenge with the AMT is that it adds back in various preferences, so taxpayers will have to do some year-end planning and may need to accelerate deductions, like prepaying state income taxes, or defer income to next year,” said Grzes, noting it may be possible to escape the AMT trap.

    Employees who are not currently maxing out their 401(k) might also consider socking those dollars away in their retirement plan, he said, which would benefit their long-term financial security and reduce their current year taxable income. They could also use the extra money to pay off any high interest credit card debt they may owe. (Related: Credit Card Problems and Fixes)

    “Those are effectively found dollars, so you won’t even miss it,” said Grzes. “If your credit card balance has an 18 percent interest rate, and you pay it off, you are effectively getting an 18 percent return on your investment.”

    Where Payday Leap Year is concerned, however, a bigger potential tax bill is not the only source of concern.

    The paycheck leap year could also cause employees to inadvertently exceed the annual limit for pre-tax contributions to their 401(k) and Health Savings Accounts, which would require extra paperwork and potentially result in a penalty, said Mike O’Toole, senior director of publications, education and government relations for the San Antonio, Texas-based American Payroll Association and author of “The Payroll Source.”

    Why the Extra Paycheck?

    How did one extra day back in February upset the applecart? It’s simple, sort of.

    Leap Day added an extra day to our shortest month this year, bringing the total number of days in 2016 to 366. The typical year has 52 weeks, plus one day, but in a leap year, there are 52 weeks and two days.

    The Leap Year anomaly occurs every four years without much fanfare, but over time, those extra Leap Days add up, creating a 27th pay period for salaried workers — who get paid biweekly — once every 11 or 12 years, instead of 26, said O’Toole. Salaried workers paid weekly get a 53rd pay period once every five or six years, instead of the standard 52. (Employees who earn an hourly wage are not impacted by Leap Years.)

    Take note that some employers already reconciled the extra Leap Year pay cycle at the end of 2015.

    Indeed, companies that issued their first paycheck of 2015 on Jan. 1 would have paid the 27th or 53rd paycheck on Dec. 31, 2015.

    Not all employees who get an extra payday, however, will benefit from a bump in pay.

    Some employers will simply divide their workers’ annual salaries by 27 pay periods instead of 26 (or 53 instead of 52), resulting in the same annual income, but slightly smaller checks.

    Others will provide that extra paycheck on top of their workers’ regular salary, which amounts to a nearly 2 percent raise for those paid weekly and a roughly 4 percent raise for employees who are paid on a biweekly basis, said Grzes.

    Either way, that extra paycheck can create a headache if you are not paying attention.

    Employees who seek to maximize the pre-tax contribution to their 401(k) retirement plan and Health Savings Account (HSA) need to divide their annual withholding by 27 (or 53) pay cycles to ensure they do not overcontribute.

    The limit for pre-tax contributions to a 401(k) this year is $18,000, plus $6,000 for those 50 or older who are eligible to make catch-up contributions.

    According to the IRS, if you overcontribute to your 401(k) you have until the income tax filing deadline (April 15 of the following year) to correct the mistake and avoid double taxation.

    The excess deferral amount, and any investment returns it earned, would simply be taxed as ordinary income.

    If you fail to notice or correct the overage by April 15, however, the overage and its earnings will be taxed in the year you contributed, and taxed again in the year you distribute the funds. 

    Similarly, excess contributions to your Health Savings Account will be taxed as income and assessed a 6 percent excise tax for each tax year the overage (plus related earnings) remains in the account — unless you withdraw the excess contributions and include the earnings in “Other income” on your tax return by the due date, including extensions, of your tax return for the year the contributions were made, according to the IRS

    The limit for pre-tax HSA contributions is $3,350 for individual coverage and $6,650 for families in 2016,

    “Employees should pay attention to their pay stubs and know how much is coming out of their pay for 401(k) plans and HSAs,” said O’Toole in an interview.

    Some payroll departments typically flag employees before they exceed federal contribution limits to their tax-advantaged retirement accounts, but mistakes do happen – especially among recent hires who may have contributed to a 401(k) at their former job.

    O’Toole suggests salaried workers check with their HR departments to be sure their retirement and HSA contributions for 2016 remain on track.

    Don’t Leave Retirement Money on the Table

    Apart from excess deferrals, employees who receive an extra paycheck this year should also ensure they are not leaving retirement dollars on the table. 

    If they don’t adjust their tax withholding to reflect the extra pay period, employees could max out their 401(k) a paycheck too early, causing them to miss out on their employer match for that last pay period of the year – especially if they are required to make a contribution each pay period in order to qualify for the match.

    Leap Day may have come and gone, but it could still impact your tax-advantaged retirement savings tools and year-end tax bill.

    Salaried workers should check with their human resources department to determine whether they are impacted by the Payday Leap Year and, if so, whether they need to make a mid-year correction to their elected deferrals, said O’Toole. 

    Those who will benefit from extra pay, should also consult an accountant or tax professional to determine whether it may impact their 2016 tax liability.

    “Employees should check with payroll to see if there might be extra paychecks this year and what they can do to protect themselves,” said O’Toole.

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    The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel.