How to Save Money with a Tax-Free Car Allowance

Written by mBurse Team Member Feb 22, 2021 7:00:00 AM

It's tax season, and filers will again be reminded that they cannot deduct miscellaneous business expenses if they are an employee. This means no mileage deduction for workers who receive a car allowance. But switching to a tax-free allowance could be a win-win proposition.

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 has made tax-free car allowances more valuable than ever to both employees and employers. But the key to achieving a non-taxable allowance is to follow certain accounting procedures.

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.

Vehicle reimbursement and tax reform

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 motor vehicle in the U.S. (at 15,000 miles/year), was $9,576 in 2019 according to the U.S. Bureau of Labor and Statistics. AAA found it to be $8,849 (2018) using a slightly different calculation procedure. Let's split the difference and say that it costs around $9000 per year to have and to drive a car. 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 $6429 in annual business vehicle expenses. As a monthly amount, that equates to $536. The math doesn't work. The employer is paying 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.

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 (56 cents per mile for 2021). 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 really only works for 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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