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.    

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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.

Mini Series – Your Paycheck

I have decided to kick off my blog with a mini series focused on your paycheck. The paycheck after all, is how the money you earn enters your life, and it is beneficial to be familiar with how your salary is impacted before the cash you earn finally reaches your pocket.

Why this mini series should interest you?

Say for example last week you loaned your friend $100. Two weeks later he pays you back but only gives you $85. You would want to know why you only got $85 and where the remaining $15 went. This can be directly linked to your paycheck, but instead of loaning money you are giving your time in terms of hours worked. To make the link say you work 8 hours at $10 an hour, but at the end of the day get a check for $71, not quite what you expected, right? Were did the other $9 go? This mini series will help answer that question.

During this mini series I will be touching on various topics such as:

  • Gross Income
  • Net Income
  • Benefits
  • Federal Taxes
  • State Taxes
  • Before and After Tax Deductions

and possibly a few others, if you have a question or specific request related to your paycheck, leave a comment and I will do my best to answer in a future post.