The first thing you want to know when getting into personal finance, is understanding your paycheck. This post is rated for high school, college students, and beginners in personal finance.
There are actually many other blogs and posts that explain your paycheck very well. You can read this one at YoungMoney.com (image is broken, but the content is accurate), or this one at credit.com, What I will talk about today is more around what you can and cannot control on your paycheck, and why that is important.
In your control – the W-4 form
On your first day or work or within the first week, you will likely fill out a form called the W-4 form. This form tells your company how much taxes to withhold from your paycheck based on any deductions you qualify for, which are then summed up as allowances. Basically, if you are accurate in filling out the W-4 form, your employer will be able to subtract the correct amount of tax from your paycheck, before giving you the rest of this money. Usually, the instructions for how to fill out a W-4 correctly are on the sheet itself, and you should google any more terms you do not understand.
Why do I say this is in your control? This is because you know yourself the best, and there are certain choices you have in life that allow you to take more allowances. Having children is one of them. Another one is actually paying home mortgage interest. If you pay a lot of interest, that is tax deductible, you can use the worksheet on page 2 to calculate how many more allowances to take, so that you don’t pay too much in taxes.
Why does this matter? If you fill out the W-4 form incorrectly, you could end up paying too little or too much in tax, and both are not ideal! If you pay too little in tax, you might have a surprise on April 15 and have to pony up thousands of dollars in taxes. If you pay too much in tax, you are essentially lending your money to the government at 0% interest rate, and unable to invest your money.
Gross pay
Your gross pay is the salary that you were offered when you first signed for the job. It is the full amount that your employer is paying you, before taxes, insurance deductions, and other miscellaneous items
Mostly not in your control – taxes, Medicare, and Social Security deductions
You are subject to federal, state, and in some cases, city taxes. The tax rates are set based on how much you earn, subtracted by the deductions you claim on the W-4 form. Those are set. The only way to try to save on this? Move to a lower tax state while maintaining a similar gross pay. Not all states in the United States have the same state tax rate.
In addition, unless laws change, you also have to pay around 6 – 8% total for social security and Medicare (more so if you are self-employed, because you also have to pay the employer’s portion of these taxes). You can read this page on the IRS to understand how much that is for you.
Why does this matter? When you plan your budget, you have to subtract these taxes and deductions from your paycheck, before giving yourself the money to spend. It is never a good idea to plan assuming you get to keep all the money you earn. Also, as I mentioned above, if at some point the taxes you spend are unsustainable, consider moving to a lower tax state in the long run to keep more of what you earn.
Somewhat in your control – insurance deductions
Included in insurance deductions are payments for your health insurance premiums, as well as any dental and eye insurance (if your company offers them), flexible spending accounts (FSA), health spending accounts (HSA), again, if your company offers them. Not all companies do.
Why does this matter? Your company will likely offer you a couple of options for health insurance plans. Some of them cost more, some of them cost less, depending on what you want in an insurance plan. Without going into details, the key here is, you have to weigh the pros and cons of each plan and figure out what makes sense for your health situation. For those of you who are young and in pretty good health, you have the opportunity to save money here by picking the cheapest insurance plan. This is not an option for those who are older or have dependents who need the health insurance, but when you are young, this is a way to save!
Completely in your control – pre-tax retirement contributions (401K, 403b, SEP IRAs, etc.)
It is completely up to you to decide how much you want to save for retirement. If your employer matches any amount of money here, at the very least, you should contribute as much as you can to qualify for the matching.
For those of you who understand how pre-tax retirement funds work, you might have asked, what if your taxes are really low? Shouldn’t you contribute to a Roth IRA? I will get back to that concept in the future. In general, the rule of thumb is, contribute as much as you can here.
Completely in your control – other pre-tax benefits such as public transportation
In big cities where you might take trains, buses, or other forms of public transportation, you might have the ability to pre-pay for your transportation before tax. If this is the case, do it. It is always “cheaper” to pay for things before-tax, than after-tax. Why?
Imagine if you earn $4,200 in a month, with a tax rate of 20%. Your monthly public transportation costs $100.
- If you decide to pay for your card pre-tax, you first spend $100 on transportation. You are then taxed on $4,100 of your income, and you pay $820 in taxes. At the end, you keep $3,280
- If you decide to pay for your card post-tax, you will be taxed on $4,200, so you pay $840 in taxes. Then from the remaining $3,360, you pay $30 for the card, and you keep $3,300
You save $20 a month by paying for transportation pre-tax, which is $240 in savings a year
Net income
Going forward, I’m going to be referring a lot to net income. After paying for taxes, insurance, and all these other miscellaneous items, you then keep the remaining money from your paycheck. This is referred to as net income. Again, assuming your taxes are correct (and it can be a bad situation if they aren’t), we start planning your budget with your net income as the very first line.
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