Your Paycheck – After-Tax Deductions

Why this should interest you?

It can lower your take home pay!

After-tax deductions are subtractions from your income after taxes are computed, therefore lowering your net income. An example of an after-tax deduction is a contribution to a Roth 401(k) retirement plan or buying into a company sponsored share purchase program (ie, buying the stock of the company you work for automatically each month).

I will use the same example from my before-tax post but change the retirement plan contribution to a share purchasing program. Again assume no other tax except federal withholding, no social security, medicare, state, local, etc.

Joe, a single male, is a video game tester and has a gross income of $2,000/month, this also happens to be his taxable income. In this instance Joe has $238.33* withheld from his pay check each month for federal taxes, leaving him with a net income of $1,761.67 ($2,000-238.33).

Next month Joe’s boss announces the company will begin offering the option to contribute to a share purchase program. Joe decides to take part and contribute $100 a month. His gross income is still $2,000/month which is still his taxable income. Federal tax withholding remains $238.33* but net income has now decreased to $1,661.37 ($1,761.37-$100) prior net income last month less the $100 contribution to the share purchase program.

After-tax deductions as you can see are fairly straight forward.

*Federal tax withholding computed using the federal tax withholding table in the post Federal Tax Withholding. Remember to convert monthly gross income to an annual amount 1st.

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Your Paycheck – Before-Tax Deductions

Why this should interest you?

You could pay lower taxes!!

Before-tax deductions are subtractions from your gross income before taxes are computed, therefore lowering your taxable income. An example of a pre-tax deduction is a contribution to a 401(k) retirement plan or payment for benefits such as health insurance.

A simple illustration (assume no other tax except federal withholding, no social security medicare, state, local, etc)

Joe, a single male, is a video game tester and has a gross income of $2,000/month, this also happens to be his taxable income. In this instance Joe has $238.33* withheld from his pay check each month for federal taxes, leaving him with a net income of $1,761.67 ($2,000-238.33).

Next month, Joe’s boss announces the company will begin offering the option to contribute to a 401(k) retirement plan. Joe decides to take part and contribute $100 a month. His gross income is still $2,000/month but his taxable income has now decreased to $1,900 ($2,000 – $100). Contributing to the retirement plan lowers Joe’s federal tax withholding to $223.33* a month, a $15 reduction from the previous pay period. Joe’s net income is now $1,676.67. It is lower than last month, but remember, he keeps the $100 contributed to his 401(k), and when you add the contribution to net income, total income equals $1,776.67 which is $15 higher than last month.

As you can see pre-tax deductions are generally good, as they allow you to contribute or spend money before it is taxed, saving you money.

Other examples of pre-tax deductions

  • Retirement programs in addition to 401(k) such as a 403(b)
  • Employer benefits such as medical insurance, dental insurance, etc
  • Flexible spending accounts
  • Healthcare spending accounts

For more information specific to your pre-tax deductions contact your employers HR department.

*Federal tax withholding computed using the federal tax withholding table in the post Federal Tax Withholding. Remember to convert monthly gross income to an annual amount 1st.

Rule of 72

The Rule of 72 is a simple calculation that can be used to estimate the amount of time it will take for an investment to double, no calculator necessary! Well I concede, maybe a basic one…unless you can divide numbers like 3.4 into 72 in your head, in which case, props to you…but most probably can’t, so grab a simple four function calculator and you will be completing compound interest problems in no time!

Example:

I am going to invest $1,000 in a money market account with a yearly interest rate of 2%. To estimate how long it would take my $1,000 to become $2,000 I would divide 72 by the interest rate of 2 (72 / 2). The answer, 36, is about how many years it would take for my initial investment of $1,000 to double. The actual amount of time it would take is 35.003 years, as you can see; using this rule we can get fairly accurate answer with no complicated math!

Bonus uses for the rule of 72

There are two other ways this rule can be utilized. First we can use it to see the effect of inflation on our purchasing power and second, to determine the interest rate required to double an investment in a certain amount of years.

Purchasing Power Example:

The inflation rate is 4% and Jill has $5,000 in her emergency savings fund which earns no interest. She is concerned about the inflation rate and wants to estimate how long it will take for her savings to lose half its value due to inflation. Using the rule of 72 she divides 72 by the inflation rate, 4 (72 / 4) to estimate 18 years. If the inflation rate remains constant Jill can assume in roughly 18 years the buying power of her savings account will be halved. Meaning if she can buy 5,000 iTunes songs today for $5,000 she can expect the same $5,000 in 18 years to only purchase 2,500 iTunes songs.

Interest Rate Required Example:

Bill is ambitious and wants to double his money in 10 years, to figure out an approximate interest rate he would need to invest at he divides 72 by the number of years, 10 (72 / 10) to obtain 7.2. In order for Bill to double his money he will need to find an investment vehicle which yields 7.2% annually for 10 years if he is to achieve his goal.

Your Paycheck – State and Local Income Tax Withholding

State and local income tax withholding is the portion of income the state or local government withholds from your paycheck. Not every state or local government assesses an income tax so there is no general rule for how such a tax is administered. Some states such as Michigan have a flat state income tax (4.35%) while others use a graduated scale similar to the federal government. For states that use the graduated scale the logic used when calculating your state withholding is the same as calculating your federal withholding (reference: Federal Income Tax Withholding)

State income tax withholding is based upon your taxable income. The definition of taxable income on the state level can seem confusing because each state has its own regulations outlining what constitutes taxable income, and there is a chance it will differ from federal taxable income. In reality determining state taxable income is just as simple as calculating it on the federal level, take gross income and subtract any allowances or dedications permitted by the state, for example, some states allow any payments to a state college tuition fund to be deducted.

Since the laws regarding state income tax vary so widely across the US I will post general information below and some useful links for those who would like a more in depth look at a specific tax rates and information by state.

The lucky ones! States with no individual income tax (states in red tax interest and dividends)

  • Alaska
  • Florida
  • Nevada
  • New Hampshire
  • South Dakota
  • Tennessee
  • Texas
  • Washington
  • Wyoming

States with a flat individual income tax rate

  • Colorado – 4.63%
  • Illinois – 5%
  • Indiana – 3.4%
  • Massachusetts – 5.3%
  • Michigan – 4.35%
  • Pennsylvania – 3.07%
  • Utah – 5%

All other states not listed use a graduated scale, reference links below for details.

The top link this is a great compilation of every state’s individual income tax rates for the years 2000 – 2011, also the key at the bottom is helpful in determining if your state has any special circumstances. The bottom link is an interactive map, just click on your state to see income, property, estate, and other tax rates.

Unfortunately, I could not find a complete list of all local tax rates by state for 2011, but below is a link that shows local tax rates by state from 2008. The link can be useful to see if your city levies a local tax but, be cautious, there has probably been many changes made to the tax code since then. If you are interested in knowing if your local government assesses an income tax I would recommend checking your city or county website.

Some important notes:

Tax law can change frequently, the percentages shown here are for 2011 only (2008 for local), however, the logic behind the calculations tends to remain constant, a quick Google search should provide the latest tax rates.

Taxes withheld from your paycheck do not necessarily equate with taxes paid. If you usually get a refund this is because more tax was withheld during the year than what you owed and vice versa, if you owed money not enough tax was withheld.

I am not a tax accountant; this post is only meant to be a quick informative overview of state and local income taxes covering the basics. For detailed questions or concerns please consult a tax professional.

What is – A Federal Withholding Allowance?

A Federal withholding allowance is the governments way of allowing you to adjust your taxable income, the basis for the federal tax withholding seen on your paycheck. Allowances are claimed on IRS Form W4, (it is one of the forms you must fill out when starting a new job). Some examples of federal allowances are:

  • Dependents you claim on your tax return (ie children)
  • If no one else can claim you as a dependent on their tax return
  • If you plan to file as head of household on your tax return

In the tax year 2011 each federal allowance claimed reduces your taxable income by $3,700.

Example:

Mark is a single male with no children and has a gross income of $50,000/year; he has no pre-tax deductions, making his taxable income also $50,000/year. A few months later Mark gets a new job and needs to fill out his W4, he realizes he was claiming no allowances before, (being just out of college when he filled out his first W4 he didn’t quite know what he was doing) and adjusts to claim 1 (no one else can claim him as a dependent on their tax return). This lowers Mark’s taxable income by $3,700 to $46,300, which also reduces his monthly federal tax withholding, boosting his monthly net income or take home pay.

An important note

You can claim as many allowances as you want on your W4, but this does not change the amount of federal tax owed in a given year. Claiming an allowance only lowers federal income tax withholding, come tax return time if you claimed ten allowances but only two actually apply (the government will check, so will any tax prep software) you will be stuck with a big fat tax bill, owing big Sam all that money which wasn’t withheld from your paycheck. On the contrary, if you receive a large refund you may want to consider increasing the number of allowances claimed, instead of waiting an entire year for that money you will receive a small piece of it every month because of reduced tax withholding.