As planners, we talk a lot about saving and investing. It’s exciting for clients to start a savings plan and see their accounts grow toward their goals. But before you begin a savings plan, it’s important to fully explore the resource from which you’re able to save: your income! I’m assuming you know how much you make, but have you ever reviewed the fun details of your paycheck?
For Part 1 of this 3-Part Series for young professionals, let’s assess the components of your income – allowances, taxes, retirement, and healthcare.
As we get started, ask yourself these questions:
- Do you know your gross and net salary?
- How often do you review your pay stub details? Do you know how much is deducted each month for benefits or savings?
- Do you ever wonder where all your money goes?
Most folks use direct deposit these days, so it’s not uncommon to hear people never see their pay stub. What is common, though, is to be shocked by the difference between your gross salary (before taxes and deductions) and net salary (after taxes and deductions). Where did all the money go?
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Tax Withholding: How to Fill Out a W-4 Form When Starting a New Job
On your first day of work at a new job, you most likely completed a W-4 Form. Also known as an Employee’s Withholding Certificate, the W-4 instructs your payroll company how much federal tax should be withheld from each paycheck. With this form, the IRS is basically saying, “Help us estimate how much you will owe in federal taxes so you can pay throughout the year to avoid a massive tax bill next April.”
In the past, when you filled out a W-4 form you needed to choose how many allowances to take. With the Tax Cuts and Jobs Act passed in 2017, the changes in tax law led the IRS to develop a new W-4 form starting with tax year 2020. The form has been made simpler and allowances have been eliminated. Note: You may also need to fill out a withholding form for states and they may still use the older format.
Most people will only need to fill out Step 1 with personal information and filing status, and Step 5 with your signature to complete the form.
There are optional parts of the form to fill out in certain situations. You should complete Step 2 if you have multiple jobs or a spouse that works. Step 3 is for claiming dependents. If married, only one spouse should fill out this section. Step 4 allows extra withholdings for each pay period or to account for deductions like itemizing, student loan interest deduction, or contributions to a deductible IRA. If you have any questions about filling out the form for your particular situation, we recommend you talk with your CPA.
General Rule: Complete a new W-4 form whenever major life changes occur (i.e. marriage, baby, death of spouse, additional jobs or side gigs) OR if your refund or tax bill is significantly higher than the previous year. In short, you can fill out a new W-4 form any time you need to make an adjustment.
So how do taxes work? To begin, it’s helpful to know which tax line items are most often found on a paycheck. I’ve listed them here (with more detail below):
- Federal Tax
- State Income Tax (if applicable)
- State Disability Tax
- Local or City Tax (not everyone pays this)
- FICA (Federal Insurance Contributions Act) – includes Medicare and Social Security Taxes
You may feel better about taxes when you learn (or re-learn) we’re on a bracket system. This means every American is taxed at the same rates for each income level. Since it’s best explained visually, here’s an example of two individuals with different incomes.
Alice: $80,000 taxable income
Loretta: $125,000 taxable income
Alice and Loretta are both unmarried with no dependents, so we’ll use the 2020 Federal Income Tax Rates for “Single” filers to see how much federal tax each will owe.
(Married filed jointly, head of household, and married filed separately have different brackets.)
State Income Tax
States either use a bracketed tax system or a flat tax (or have no income tax at all!). Click here to see what’s applicable for your state.
Like the name suggests, this tax funds our country’s Medicare program, which is the federal health care program for retired or disabled individuals. It’s a flat 1.45% tax every American pays on gross wages before any retirement contributions are made. This means that deferrals to an employer retirement plan do not lower your Medicare taxes owed. An additional .09% tax is added for individuals earning over $200,000 in wages.
Social Security Tax
This is a 6.2% tax on gross wages up to $137,700* before any retirement contributions are made (i.e. deferrals to an employer retirement plan do not lower your Social Security taxes owed). Any income earned above that amount is not subject to Social Security tax. That’s why folks with high income notice this tax only applies to them for part of the year and stops once they’ve earned over $137,700.
Medicare and Social Security taxes are often combined on your paycheck and labeled as FICA. They are also referred to as payroll taxes.
*This amount changes annually.
Retirement and Healthcare
In addition to taxes, you’ll likely have other payroll deductions as well. The most common deductions include retirement plans, medical insurance premiums, disability insurance premiums, and health savings accounts.
Any amount you “defer” to an employer-sponsored retirement plan is not subject to federal or state income taxes, but is still subject to FICA tax. In the above example, Alice’s taxable income was $80,000. Her gross income could have been $90,000, but she deferred $10,000 to her retirement account. Therefore, she was only taxed on $80,000 for federal and state taxes, but was still taxed at $90,000 for Social Security and Medicare taxes. Retirement accounts that qualify for pre-tax contributions include SEP and SIMPLE IRAs, TSAs, and 401(k), 403(b), and 457 Plans.
As an employee, if you’re responsible for paying a portion of your healthcare premiums, that amount will also lower the amount you’re taxed on – which lowers your federal, state and FICA taxes. Also, if you have a health savings account (HSA), any contributions will lower your federal, state, and FICA taxes (as long as they’re made via payroll deductions). Contributing to an HSA from your bank account does not qualify.
If your company offers a Roth 401(k) or Roth 403(b) option, contributions to those accounts will NOT lower your taxable income since they are made “post-tax” (not as a deferral).
Managing Your Money with Confidence
Phew! We got through all the paycheck details and now you know the ins and outs of your saving resource! Check out Part 2, “6 Simple Steps for Managing Your Money,” where we cover how to best allocate your spending, saving, debt paydown, and investing. Reach out to a financial advisor today to begin defining your goals and learning how to expand what is possible with your money.