What You Should Do with Your 2011 Payroll Tax Break

The compromise deal hammered out earlier this week that will extend the Bush tax rates through 2012 -- assuming the Democratic caucus heeds President Obama's scolding yesterday -- is in fact a stealth economic stimulus deal. Moody's Analytics economist Mark Zandi, who advises plenty of D.C. policymakers, estimates that the cumulative impact of the deal could add 1.2 million jobs and push GDP growth next year to 4 percent.

For starters, the agreement to extend unemployment benefits for 13 months doesn't merely help the millions of out-of-work Americans, but it's also known to have a big stimulative bang-for-the-buck payback. People who receive those benefits tend to turn around and spend it back into the economy ASAP.

Another major stimulus factor is the proposal to reduce the Social Security payroll tax in 2011 for employees from 6.2 percent to 4.2 percent. (Employers will still have to pay their 6.2 percent.) In effect, we all just got a raise courtesy of Uncle Sam. If you make at least the $106,800 that is the maximum earnings subject to the payroll tax, your 2011 take home pay will be $2,136 higher compared to this year. For high earner couples, that's another $4,000-plus of disposable income at your fingertips.

But here's the $120 billion question (that's the reported cost of the payroll holiday): What are you going to do with that extra money? Here's a cheat sheet on some options, in descending order of their impact on the economy:

1. Spend it. Want to help the economy? Go out and spend your mini-windfall. It helps your local economy -- and yes, Amazon too -- and that will, fingers-crossed, spur businesses to expand. Granted, President Kennedy had loftier ideas in mind when he suggested we all ask what we could do for our country, but he wasn't dealing with the lingering hangover of a severe financial crisis and recession. If you want to do your part to rev up our still anemic GDP growth, go out and spend it all.

2. Invest it. Using the money to boost your 401(k) contribution rate in 2011, or fund a Roth IRA strikes me as a mighty fine idea, but in fact it's not nearly as patriotic as spending the money. This strategy merely plays along with the virtuous-cycle philosophy that is a large part of the Federal Reserve's quantitative easing policy: If more of us invest our money in the stock market, it will benefit those businesses. The theory is that businesses will turn around and pick up their hiring pace. To date, that theory is being tested mightily as corporate America seems to be auditioning for a spot on A&E's Hoarders show given how big business is holding onto cash. To repeat: if you're really looking to step up and do your stimulative duty, spend the money, don't save it. If you're resolutely focused on investing for your long-term security, well, OK. My MoneyWatch colleague Conrad deAenlle offers up some smart investing ideas in 10 Great Stock Picks That Pay Great Dividends and 5 Top Value Stocks. And instead of getting too swept up in the current rage for emerging markets, be sure to check out Allan Roth's take on Europe on Sale.

3. Save it. While not grounds for treason, using your 2011 tax break to increase your emergency savings, or pay off debt is the least stimulative move you can make. But why should corporate America be the only ones to hoard cash these days? If there's one major takeaway from the Great Recession and the stubbornly high unemployment rate, it's that fortifying our household balance sheets is smart protection.

A couple of saving ideas:

Make an extra mortgage payment. Your 2011 tax break might be enough to add a 13^th mortgage payment (and maybe a 14^th) next year. Yes, we're well aware at MoneyWatch that this might not make the most "financial" sense, but some things, at least for some of us, exceed straight financial calculus. Paying off your mortgage ahead of schedule has a huge psychological pay off. Use your 2011 tax break to jumpstart your pay-off plan. Make that an annual ritual and you can shave a few years off of your payment schedule.

Search out the best bank rates. If you're looking to boost your emergency savings account, don't settle for whatever your current bank is offering. The fact that interest rates are so miniscule makes it all the more important to seek out any opportunity to earn as much as you safely can, such as by looking into the Last Great CD Rate.

The choice is yours. I'd just put in a pitch for making sure your retirement savings is in good shape. If recent history -- as in this week -- is any guide, temporary tax deals have a way of becoming quasi-permanent tax deals. It's hard to imagine that if come this time next year unemployment remains above 8 percent, as it's expected it will, that Washington would risk letting this tax holiday expire in 2012. While that might be welcome news for your household's current cash flow, it impacts the financial stability of Social Security, since there will be less money coming into the system. And that could intensify the debate on how to "fix" Social Security. As we already know from the recent deficit commission proposals, that could take the form of any number of moves. Including raising the current earnings limit on the Social Security payroll tax.

Photo courtesy of Flickr user AComment

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