What is a Vesting Period?

A vesting period, when mentioned in reference to retirement plans, is the length of time an employee must work for a company before he or she can claim 100% of employer provided benefits. The term vesting period is most commonly used with retirement plans like a 401(k) or pension, but may also be used with stock options.

Example: My current employer requires that I work five years before I am 100% vested in my 401(k). This means if I leave and go to another company before that time I will forfeit my right to the employer contributions made to my 401(k). It doesn’t however mean I forfeit 100%, my company has an incremental vesting period, meaning each year I work for them my vested percentage increases.

  •   2 years: 40%
  •   3 years: 60%
  •   4 years: 80%
  •   5 years: 100%

Each company is different however and for some it may be 0% until the vesting period elapses.

Let’s say I leave my current company after 3 years, and up until that point I have contributed $5,000 to my 401(k) which my employer has matched, giving me total of $10,000 (not counting any gains or losses). When I officially leave my 401(k) will be reduced to $8,000 in total, I would only be entitled to keep 60% of the company match or $3,000 ($5,000 x 60%) in addition to what I have contributed.

Note that vesting only applies to contributions from your employer, everything you contribute you keep. Any gains incurred because of the employer contribution are also forfeited but any gains on your contribution or vested amount is yours to keep

Advertisements

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.    

What is – Taxable Income?

Taxable Income – The monetary base from which you are imposed a tax. Taxable income for the federal government is usually any income received over the course of the year (gross income) less deductions (such as a federal allowance or 401k contribution) and expenses as deemed allowable by the IRS. Taxable income at the state level is determined by the state’s taxing authority and can differ from the federal government and from state to state.

Simple example: John has a gross income of $50,000/year he contributes $5,000/year to his 401(k) retirement account and has claimed one federal allowance on his W4. In this case John’s taxable income would be $41,300.

Gross Income: $50,000

Less 401(k): $5,000

Less Allowance: $3,700

Taxable Income: $41,300 (this is the number you would use when referencing the IRS withholding tables to determine withholding)

Bottom line, taxable income is the number used to calculate the taxes you owe, whether it is to the federal, state, or local government.

Your Paycheck – Gross Income vs. Net Income

Why this topic should interest you?

Many people know what their gross income is, but that is rarely the amount of money they take home. Knowing your salary, take home pay, and the reasons why the two differ can prove helpful in successfully managing your personal finances.

Gross Income

This is the number you knew when you had your first part-time job at insert name of first job here making $5.50 an hour, and the number you will know when you land that big full-time job with a $45,000/year salary. In other words it is what you make before any deductions, like taxes and benefits.

Net Income

When you start a new job and get the first paycheck this is the number that usually makes you go WTF?! I thought I was making more than that! It is your gross income less any deductions, like taxes and benefits. It is the final number you see on your paycheck or the number that is directly deposited into your bank account, it can be referred to as your take home pay.

It is important to note that this number can differ significantly from person to person even if their gross income is the same; this is due to differences in deductions.

Deductions

These are items like federal and state taxes and are subtracted from your gross income.

Example

Below is an example of a monthly paycheck, as you can see gross income is $1,875.00 but take home pay is only $1,445.07, this is because of the deductions that occur before the check even reaches your bank account (+ denotes income, – denotes deduction)

+ Monthly Salary (Gross Income)           + 1,875.00

+ Flex Benefits Credits                 + 188.24

– Federal Taxes                             – 308.60

– State and Local Taxes                – 0.00

– Before Tax Deductions               – 309.57

– After Tax Deductions                  – 0.00

= Net Income (Take Home Pay)             = 1,445.07

Now that you are familiar with the difference between gross and net income my next few posts will dig into the different types of deductions above and explain what they are and how they affect your paycheck.