With inflation at a 40-year high, and fuel costs being a primary driver, is it time to increase your car allowance? The short answer is "Yes." But the way to do it might not be what you expect.

Consumer prices increase at 40-year high – what it means for your car allowance

In June 2022, the consumer price index continued to increase rapidly. Compared to May 2022, prices were up by 1.3%. Compared to June 2021, the increase was 9.1%, which is the highest increase since 1981. 

With gas prices averaging more than $5/gallon in June, it is no surprise that the increase was this high. Gas prices have fallen somewhat since then, but that does not mean that employees who receive a car allowance are not going to continue to face significant economic pressure.

The prices of both new and used vehicles remain historically high, and with the costs of many materials running high as well, the costs of vehicle maintenance are affected by inflation. All in all, if your organization has not already increased its employee's car allowance, it is clear that a change is likely necessary.

How to calculate a company car allowance increase

Increasing a company car allowance seems as simple as just increasing the monthly payment by what seems a reasonable amount. You could, for instance, calculate the percent increase in the average costs of vehicles, fuel, and maintenance in the years since you last increased your car allowance, and use this number to guide your decision.

Or you could go a step further and calculate the average monthly business vehicle costs of a few employees and see what the difference is between that number and the current allowance amount. This would take more time but would give you more precise information.

However, there's one key factor that you cannot ignore: taxes. Because a standard car allowance is taxable income under IRS rules, you have to calculate the after-tax amount of the allowance to see how much of an increase is needed. In many cases taxes can eat up 30 or 40 percent of the allowance amount.

So the increase needed might be bigger than you think.

How to pay for a car allowance increase due to inflation

Eliminating taxes is the key to paying for the increased car allowance. If you can restore that 30 or 40 percent cut back to the employee, that might cover all the cost increases that have resulted from inflation and actually save money overall.

Of course, if the previous allowance amount was not calculated with tax withholding in mind, the gap between employees' cost needs and the monthly amount might be bigger than you expect.

Either way, the key is to eliminate taxes and use that money that was going to the IRS to pay for a fairer, more robust car allowance. Your employees work hard and expect to be treated fairly, and this is an opportunity to do right by them during an inflationary economy that is putting pressure on everyone.

How to use a non-taxable allowance to address vehicle cost inflation

Switching to a car allowance is not as simple as just switching to paying the IRS mileage rate (62.5 cents per mile as of July 1, 2022). This approach can work for some companies, but not for others. If employees work in areas that are very expensive compared to the average or drive far more or far less than average, then that rate will significantly over-reimburse or under-reimburse them. 

The better approach to paying a tax-free car allowance is to adopt what the IRS calls a fixed and variable rate car allowance. This approach takes into account the differences in costs between geographic areas and takes into account travel mileage in a more sophisticated way than a standard mileage rate.

A fixed and variable rate (FAVR) approach is the most accurate and cost-effective way to pay for employees' vehicle travel costs. It automatically adjusts for inflation and guarantees compliance with labor codes in states like California that require full reimbursement of business vehicle costs.

To learn more about whether a tax-free car allowance would work for your organization, schedule a call today, or try our tax savings calculator.