How to calculate exemptions and an overview of how federal taxes are withheld from your paycheck.
To calculate how much is taken from your paycheck for taxes your employer uses a formula. Each state is different, but federal taxes use the same type of formula. When you first get hired you fill out a bunch of paperwork. One of the forms you sign is called your W-4. This form determines how many exemptions you take. When you first start out, you should probably be claiming zero exemptions. If your parents are still claiming you as a deduction (which they may do if you just graduated this year) you definitely want to claim zero exemptions in order to avoid owing any more tax than necessary next April.
For each exemption you take, the government basically “exempts” a certain portion of your paycheck from being taxed, so the more exemptions you take, the less that comes out of each paycheck. However, at the end of the year (actually when you file your taxes by April 15th) your entire tax liability is computed based on your income for the year, so if you took too many exemptions and did not have enough taxes taken out of each paycheck, you will owe the difference at the end of the year.
In other words, the number of exemptions you claim on your W-4 does not affect the total amount of taxes you will pay by the time you file in April; it only affects how much you pay each week. Below is a sample of how the formula works (the numbers change each year because tax brackets adjust slightly to account for inflation).
To make this a little clearer, let’s look at an example. If you earn $26,000 per year and you are paid every two weeks (bi-weekly), your gross earnings on each paycheck will be $1,000. After deducting for your 401(k), health insurance and FSA, and taking zero exemptions, your taxable income is $835.00. According to Figure 5-2, your withholdings will be $28.70 plus 15% of the amount over $389. Since $835 is $446 over $389 ($835 minus $389 = $446) you will pay $28.70 plus 15% of $456, which is $28.70 plus $66.90 (.15 x $446 = $66.90). Your federal tax withholding will total $95.60 ($28.70 plus $66.90 = $95.60). Of course you will also pay state, social security and Medicare taxes.
Keep in mind how you are taxed throughout the year doesn’t really affect the total amount of taxes you owe for the year. Simply stated, you either pay too much as you go along, and get money back when you file the following year, or you pay too little from each paycheck and you owe money when you file the following year. Occasionally you may pay exactly what you owe, but usually you’ll be off by at least a few dollars in either direction.
Stretching Your Paycheck
I know what you are thinking. I can’t believe I went through four years of academic torture just to come out on the other side and have to watch where and how I spend my money!
Your parents have more money than you. In many cases your parents make more money than you, especially when you first start out. Don’t feel too bad, because you can’t forget that your parents have been working for more than 20 years.
Even if they don’t make more than you, they probably still have more money than you. Here is why. For one, there’s inflation. My parents had a house payment of around $300 because they bought their home years ago. When I tried to find an apartment, I was paying more than twice that amount. My townhouse cost about four times what my parents paid for their home! You see, I would have to make a lot more than them just to break even after rent (or mortgage).
Another reason your parents have more money than you is because of the years they have had to save. That’s right, they have since paid off their college loans (if they had any), and hopefully their other debts as well. They may have even paid off their mortgage.
A third reason your parents have more money than you… and I hate to admit it… is because they are smarter than you. Remember I am still only talking about money here. Just remember who it was that always left the television on and the lights on and the door open. Was it your dad? No, he was going around closing doors and turning off lights (all the while grumbling, I’m sure).
Your parents have learned through the years how to make their dollars go further (they had to when they had you). Usually, they don’t even have to think about it any more, it just comes naturally. After all, you weren’t “raised in a barn.” I do have two pieces of good news. First, you don’t have to admit your parents are smarter than you. Second, after you finish this book, you’ll be smarter than them! That’s right; you’re going to be twenty years ahead of your time in terms of financial knowledge.
Next week we will look at ways to stretch your paycheck so you can get much more for your money.