Taxes and my Paycheck

When I moved here one of the financial mysteries for me were the taxes on my paycheck, what would be deducted and more importantly how much should I withhold to meet my tax obligations. I learnt the importance of understanding this the hard way with a hefty tax bill, due to not withholding enough taxes during the year. Luckily I had sufficient funds to pay the tax liability and there was no fine as this was the first year I owed taxes. If I owe taxes again next year, there will be a $300+ fine. With this in mind, I thought I would summarize my learning experiences around the taxes in ones paycheck and how they are calculated. I work in large Fortune 100 corporation, which outsources it paycheck process to a national payroll company, so I imagine it contains most of the common elements present in paychecks.

Here are the key items and related tax details that you should be aware of:

1. The paycheck should have all your correct personnel details listed near the top - especially your location and tax marital status (married or single). If incorrect, you need to contact your HR or Payroll department to fix these as soon as possible because they can affect your taxes. Per the tax tables at the end of this post tax rates and thresholds vary greatly by marital status.

2. The next section to look at is your Federal and State Exemptions (or Allowances). These are very important and suffice to say, could make the difference whether you pay taxes or get a refund at the end of the year. The exemptions you take will affect how much tax is withheld (deducted) from your paycheck to meet your annual expected tax liability. Generally the more exemptions you take the less tax is withheld during the year. The details behind this is separate post in itself, but the Internal Revenue Service (IRS) has detailed guide book and calculator (link below in references) to help you determine the appropriate number of allowances (or additional tax withholding) for your situation. It is long, but take the time to read it. When in doubt take zero exemptions.Talking to others I found that if you are renting or taking the standard deductions in your tax return, selecting no exemptions is the safest option. However this will vary for everyone based on their own individual situation.

3. The rest of your paycheck should contain your income details and various taxable and non-taxable deductions (like health insurance or 401K contributions you have elected to make). Remember your federal and state taxes are calculated on your Adjusted Gross Income. Next, look for a section that breaks down your withheld taxes and you should see the following four items :

- Fed Withholding - This is the amount of federal taxes you are having withheld. America has a PAYG (pay as you go) progressive taxation system where taxes are set aside or withheld from your paycheck during the year rather than having one massive tax bill at the end of the year. Think of this as the taxes you are paying in advance. You can choose to have less tax withheld in each paycheck by increasing the number of exemptions/allowances you select in step 2. Alternatively you can choose to have more tax withheld if you feel that the standard withholding is not sufficient. The IRS guide book referenced above can help with this as can the W4 form you use for submitting your exemption requests. See the tables at the end of the post for the 2008/9 tax tables to get a rough idea of what your annual tax liability will be. For example, on a $50,000 adjusted gross income your tax federal tax would be about $16,981 (25% single tax bracket) that works out to $653 per biweekly pay period. If this amount is not being withheld from your paycheck you could be liable for taxes at the end of the year.

- Fed MED/EE - is the Federal Medicare tax. This should be 1.45% of your gross salary.

- Fed OASDI/D - Federal Old Age Survivors Disability tax, which is also known as the Social Security tax. The idea is that this will be paid back to you as a pension when you retire. It is debatable whether this will be the case given government spending, but that is the subject of another post. The Social security tax rate for wages paid in 2008 is 6.2% of gross salary (to a limit of $102,000, after which it is fixed at $6,324). Your employer contributes a matching amount on your behalf.

- [State] Withholding - As with your federal withholding you withhold taxes for your state income tax liability. Each state has a different tax rate so withholding amounts will be different by location. Click here for a listing of state income tax rates.

Hopefully this article should help you get started on understanding your paycheck and taxes in it a little bit better. It is also a good guide to review your current paycheck. Take the time to ensure that the correct taxes are being withheld so that you don't have a large tax bill at the end of year. On the flip side, you also don't want too withhold too much and have a big refund in the subsequent year. This is because you are giving up money you rightfully should have and could have invested, as opposed to a free annual loan to the federal and state tax departments. Using last years returns and references in this article should help you determine the right of amount of taxes to withhold. If you have any feedback on the above or additional tips, do leave a comment.

Supplementary information

Your paycheck will probably contain a lot of other information not mentioned here. So here are three good samples I found online with descriptions for all sections normally in a paycheck. Click the following links to view them: Example 1 and Example 2 and Example 3

US Tax Schedule 2008/2009 and Rates for Single Filing Status

10% on income between $0 and $8,025
15% on the income between $8,025 and $32,550; plus $802.50
25% on the income between $32,550 and $78,850; plus $4,481.25
28% on the income between $78,850 and $164,550; plus $16,056.25
33% on the income between $164,550 and $357,700; plus $40,052.25
35% on the income over $357,700; plus $103,791.75

US Tax Schedule and Rates 2008/2009 for Married Filing Jointly

10% on the income between $0 and $16,050
15% on the income between $16,050 and $65,100; plus $1,605.00
25% on the income between $65,100 and $131,450; plus $8,962.50
28% on the income between $131,450 and $200,300; plus $25,550.00
33% on the income between $200,300 and $357,700; plus $44,828.00
35% on the income over $357,700; plus $96,770.00

Definitions in your paycheck to know from a taxation perspective:

Gross Salary is the amount your employer pays you before any deductions, i.e., John gets paid $50/hour as an electrical engineer. His annual gross salary is $50/hour x 2,000 hours/year = $100,000/year.

W-2 Wages = Gross Salary less (contributions to employer retirement plan) less (contributions to employer health plan) less (contributions to some other employer plans)

Adjusted Gross Income (AGI) is Total Income (Gross Salary, bonuses and other income) less some specific allowed deductions (such as; alimony, home or student loan interest etc)

Resources:
IRS Detailed Guidebook