Do you remember what it felt like to get your first paycheck at your first job after college? It’s an incredibly proud moment – but it can also be a somewhat confusing moment.
That seems low – does that seem low? You ask yourself while looking at the direct deposit in your bank account.
Many young professionals have this same back-and-forth with themselves when they first start receiving a paycheck. Most of the time they’re not fully sure what taxes are getting taken out, or what benefits they’re paying for – and they’re a little too intimidated to ask.
But here’s the thing – understanding your paycheck is a game changer. It helps you to plan for taxes, maximize your workplace benefits, and organize a cash flow system or budget to get you through your day-to-day finances.
Your paycheck is made up of a few different pieces:
- Your gross earnings
- Your taxable earnings
- Your net pay (this is what you take home – yay!)
Your gross earnings are what you earned – this is often the salary that you accept on your offer letter, or that’s written on your contract. Your withholdings are typically for federal and state taxes, Social Security, and Medicare. Other deductions could be health care, pre-tax 401(k) contributions (or other workplace retirement plan contributions), and any other benefits that are tax deductions that you get through your employer.
Avoid Surprises: Change Your Withholding
The number one question I get from clients about their paycheck is, “Why did I owe money last filing season?”
If you owe money when you file your taxes, you’re probably not withholding enough from each paycheck. The new tax law only impacted your federal taxes – which means that FICA and Medicare tax rates weren’t adjusted. You need to make sure that you’re withholding enough from each paycheck to cover all of these taxes – not just the percentage of federal income tax you’re anticipating.
The easiest way to adjust your withholding is to adjust your W-4 with your employer. A W-4 form helps you to let your employer know how many dependents you have – and how much they should withhold from your paychecks for taxes accordingly. You should be completing a W-4 whenever you start a new job, but you should also fill one out when your marital status changes, when you have a kid, buy a house, gain a dependent (like an adult parent moving in with you), taking on an additional job, when you get a raise, or if you find that your tax refund was too large last season – or if you owed money.
Your W-4 will help walk you through the steps you need to take to calculate how many allowances you can take based on all of these different factors – which helps your employer know how much money to withhold for taxes!
Understanding Your Tax Break-Down
Social Security and Medicare are automatically withheld by your employer at fixed rates. Right now, the Social Security rate is 12.4% (6.2% is for your employer, and 6.2% comes from you). The Medicare rate is 2.9% (again – this is split in half between you and your employer).
Then, your employer withholds an estimated federal income tax based on your marginal tax rate, and an estimated state tax (which is different from state to state). When you don’t withhold enough tax, you’ll likely owe money to the IRS next filing season. However, there are other reasons you might owe when you file. For example, you might have rolled over a 401(k) to a Roth IRA, or you may have purchased and registered a car that you’ll owe taxes on.
Know What You’re Paying For
When you’re deciphering your paycheck, you may notice several deductions that you didn’t know impacted your pay. Some company benefits are deducted from your gross pay. This saves you money on taxes, but is worthless to you if you don’t use the benefits! Take this opportunity to explore what benefits you’re paying for – and make sure you take advantage of them.
How Much Should You Withhold?
The trick is to balance your withholdings in a way that dials in your taxes as close to what you actually owe come filing season as possible. Many people believe that over-withholding is a safe way to ensure that they’ll get a big tax refund at the end of the year. In fact, our society has hyped up tax refunds so much that stores run “tax refund sales” intended to get us to spend our refund with them!
The truth is that if you get a big refund, you’re just giving the IRS an interest-free loan for up to 12 months. That money could be growing in a savings account, be put toward achieving your debt repayment goals, or be used in your day-to-day cash flow over the course of the year. So, take the extra time required to make sure that your W-4 is filled out correctly, and that your company is withholding the right amount of taxes from your paycheck. You can also contact our team at Deerfield Financial Advisors – we’re more than happy to help you break down your paycheck to decipher your withholdings, and plan ahead for tax season.