How to Save Money with a Tax-Free Car Allowance

Written by mBurse Team Member   |   Dec 12, 2022 7:00:00 AM

The story of 2022 heading into 2023 is inflation. Everyone is experiencing higher costs. One way for your business to reduce costs is to switch from paying a standard car allowance to a tax-free car reimbursement.

Tax-free car allowance vs. standard allowance

Paying a monthly car allowance is one of the most common ways for employers to offset the vehicle expenses of employees who drive as part of their job. It is a simple arrangement with no accounting necessary, which is why most car allowances are treated as taxable income by the IRS.

Prior to the 2019 tax season, employees who received a car allowance could deduct their business mileage for the previous year at the IRS standard business rate. Receiving this tax deduction helped to balance out the taxes withheld from their monthly allowance amount.

But the Tax Cuts and Jobs Act passed at the end of 2017 eliminated this helpful tax write-off for tax years 2018-2025. This change was essentially a cost increase for employees receiving a standard car allowance. A few years into this changed policy, the prices of vehicles are higher than ever, gas prices are high, and auto insurance rates have increased.

Tax-free car allowances are more valuable than ever, offering a key way for businesses to boost employee take-home pay while reducing overall costs. But the key to a non-taxable allowance is a set of accounting procedures.

Calculate your 2023 car allowance - for free

Let's explore why adding accounting procedures to a car allowance program is worth it – and how much both employers and employees could save by switching to a non-taxable allowance.

Tax withholding for car allowances

When you consider just how much tax is withheld from the typical car allowance, you begin to see that it is not a particularly good deal for most employees. Depending on the employee's tax bracket and whether the employee lives in a state with an income tax, as much as 40% of the allowance could be taken out for taxes.

The average car allowance is somewhere around $600 per month. Let's say an employee receiving this allowance gets taxed at a rate of roughly 33% (including income taxes and Social Security/Medicare). That leaves only $400 per month after taxes. Or let's say that this employee lives in California, Oregon, or Minnesota, where the average state income tax is around 7%. Now they're only taking home $360 of that $600.

The average expense of owning and operating a new motor vehicle in the U.S. (at 15,000 miles/year), is $10,728 in 2022 according to AAA. An employee driving five days every week for business should see at least 5/7 of that number as a business expense.

That leaves us with $7663 in annual business vehicle expenses. As a monthly amount, that equates to $638. With a $600 monthly allowance the math doesn't work. The employer is paying slightly more than that amount ($646 when you factor in their portion of FICA/Medicare). But the employee is only receiving around $400 or maybe less. (When you factor in tax withholding, even a $700/month allowance will not cut it.)

Computer mouse on desk selecting step 1

Tax-free mileage reimbursements

In order to eliminate the tax waste from a typical car allowance, some organizations switch to paying the IRS mileage rate as a reimbursement (65.5 cents per mile for 2023). These payments are non-taxable and only require the addition of mileage tracking as an accounting procedure.

But paying a standardized mileage rate comes with its own problems. This is because a vehicle becomes less costly per mile the more a person drives. AAA found quite a range, depending on annual mileage.

For a medium sedan:

10,000 miles annually = 71.6 cents/mi

15,000 miles annually = 54.5 cents/mi

20,000 miles annually = 47.1 cents/mi

For an SUV, those same numbers were 82, 63, and 55.2, respectively.

This means that the IRS mileage rate only fully covers a medium sedan driven 15,000 miles per year or an SUV driven 20,000 miles per year. Other combinations will leave an employee either under-reimbursed or over-reimbursed.

Turn taxes into savings with a tax-free allowance

The best way to help the company save money while beefing up each employee's car allowance is to institute a tax-free car allowance, rather than a tax-free mileage rate.

The IRS describes two different accounting procedures that can make a car allowance tax-free. One is the mileage allowance, also known as mileage substantiation. The other is the fixed and variable rate allowance, also known as a FAVR car allowance.

Both involve complicated accounting procedures, but FAVR in particular is well worth it, bringing a quick return on investment. The money saved in taxes is more than enough to pay for program administration, allowing your organization to outsource the accounting part and keep everything simple for both management and drivers.

You can easily calculate your organization's prospective savings with a switch to a non-taxable car allowance by using our calculator, which compares the costs of your current car allowance with the costs of a FAVR car allowance:

Compare your vehicle program to a FAVR Plan

Or if you'd like to take a deep dive into what FAVR is and how it works, follow the link below.

FAVR car driving on highway

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