Get the scoop on what’s deducted from your pay and when you need to adjust your allowances.
In this episode I’ll discuss payroll tax withholding. Understand what exactly is taken out of your paycheck and when you’ll need to adjust your allowances.
How Withholding Works
When you take a new job, one of the forms you complete for your employer is the W-4. This form tells your employer how much taxes should be taken out of your pay. The money that comes out of your gross check is called withholding, because it's withheld from you and goes to the government instead.
Federal income tax is called a "pay-as-you-go" tax because you must pay up as you earn money during the year. Withholding is a tax collection method that benefits the government because it reduces the chances of tax evasion. It also puts the administrative burden of collection on employers who are required to calculate and submit income taxes on behalf of their employees.
Completing a W-4
Your tax withholding is based on the number of allowances you claim on form W-4. An allowance is the same as an exemption from tax. The more allowances you claim, the less federal income tax will be taken out of your paycheck.
It's important to note that you can file a new W-4 with your employer anytime your personal situation changes. You can adjust the number of allowances to avoid having too much or too little tax withheld.
Your goal should be to have your withholding match the actual amount of tax you will owe. If too little tax is withheld, you'll owe tax at the end of the year and may also have to pay interest plus a penalty for not paying on time. If too much tax is withheld you lose the use of those funds until your money is refunded.
Check Withholding Annually
It’s a good idea to review your tax withholding at the beginning of each year. Some employers may send out a reminder notice about this, but others may not. Significant events such as marriage, divorce, the birth or adoption of a child, retirement, or the purchase of new home will affect your tax liability. Other changes that affect income such as losing a job, taking on an additional job, or an increase or decrease in salary should prompt you to review your withholding any time in the year.
Adjustments to income such as a student loan interest deduction or alimony will affect your tax liability. Changes in itemized deductions or tax credits like medical expenses, education credits, and child tax credits should also be a signal to review withholding. If you have additional income not subject to withholding such as interest, dividends, capital gains, etc. you'll want to make sure you have enough tax being withheld.
Here's a handy link to the IRS Publication 919 titled How Do I Adjust My Tax Withholding?
What Gets Withheld
Employers are required to withhold 4 different types of taxes from employees' paychecks:
Federal Income Taxes
State Income Taxes
Social Security Taxes
The last two, Social Security and Medicare, are collectively called FICA. This stands for the Federal Insurance Contributions Act tax. Most of you know that Medicare is the federal program that provides hospital insurance benefits once you reach the age of 65. The benefits provided by Social Security are summarized by the program’s official name, OASDI. This acronym stands for old-age, survivors, and disability insurance.
Employers Pay Up Too
Many people don't realize that employers are also required to pay a matching amount of FICA for each of their employees with every paycheck. So the amount of Social Security retirement benefits that you will receive is directly related to the amount that you and your various employers have paid into the program over your entire working career.
How Much is Withheld?
In 2008 and 2009 the tax rate for Social Security is 6.2%. So employers withhold this amount from your gross wages in addition to paying another 6.2% of the company's money for you. This tax is paid in each year until a wage threshold is reached. For 2008 the wage threshold is $102,000 and it will be raised to $106,800 in 2009. Once you earn the wage base amount, neither you nor your employer must pay any more Social Security tax.
The Medicare tax rate is currently 1.45%. There is no wage base for the Medicare portion of FICA tax, so both the employee and the employer pay a combined total of 2.9% no matter how much is earned.
If you're self employed, you pay both the employee and employer side of FICA tax for a grand total of 15.3%. That's 12.4% for the Social Security portion up to the wage threshold and 2.9% for the Medicare portion.
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Chi-Ching, that's all for now, courtesy of Money Girl, your guide to a richer life.
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