When it comes to our paycheck, we tend to focus on the bottom line and think about how we’ll spend or save that money. But some of the most important decisions for our financial future are among the myriad of deductions above that line. Unfortunately, they’re often hastily determined in a flurry of paperwork when we first start a new job and are never revisited.
With summer coming to an end and open enrollment coming up for many employers, this is as good a time as any to take a closer look at your paycheck. In fact, the American Payroll Association decided to designate this week as National Payroll Week, which is a campaign to help American employees better understand their paychecks and their payroll-driven benefits. Let’s take a look at some of those deductions and how they can affect your financial well-being:
Estimated Payments: Having tax withheld from your paycheck allows you avoid penalties on not paying enough taxes throughout the year.
Pitfalls to Avoid: Having too much tax withheld means providing a no-interest loan to Uncle Sam. You can use the IRS’s withholding calculator, which will be available starting in mid-September, to estimate how many allowances to declare.
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Employer Match: If you’re fortunate enough to have an employer that matches part of your contributions, you’ll want to try to contribute at least enough to max the match. Otherwise you’re leaving free money on the table.
Tax Deferral: Pre-tax contributions allow you to defer the taxes until you withdraw the money from your plan. This has a couple of advantages. First of all, lowering your taxable income could make you eligible for additional credits and deductions. Second, you might be in a lower tax bracket in retirement if you’ll need less income than you make now. But even if you’re in the same tax bracket, you could still end up paying an overall lower rate in retirement since some of your income will be taxed at lower brackets. Finally, even if you pay the same tax rate, you’ll have the additional earnings on the money that would have gone to taxes each year.
Tax Free Growth: Some plans also allow Roth contributions, which can grow tax-free after 5 years and age 59 1/2. These can be particularly beneficial if you max out your contributions or expect to be paying a higher tax rate in retirement.
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Retirement Income: For the reasons above, this is usually the biggest voluntary deduction for most people but it’s still not big enough. According to our latest research, 92% of American employees are contributing to their employer’s retirement plan but only 18% know they are on track for retirement. So how much is enough? The National Graduate Institute for Policy Studies calculated that if you work for 30 years, invest in a 60/40 split between stocks and bonds, and then retire for 30 years on Social Security and a 4% initial withdrawal from your portfolio adjusted annually for inflation, you’d have to save 12-15% of your income each year to retire with an income of half of your final year’s income. Of course, your situation may be different so you’re better off running your own numbers.
Automatic Contribution Rate Escalator: If you need to save more but can’t afford to dramatically increase your contribution rate, see if your employer offers this feature, which allows you to automatically and slowly increase your contributions until you’ve hit your target rate. For example, if you’re putting in 6% to your 401(k), you can have that go up 1% per year until it reaches 15%. In his book The Automatic Millionaire, David Bach shares real stories of how ordinary people built up extraordinary wealth by slowly increasing their saving like this over time.
Investment Options and Advice: Your retirement plan may offer unique investment options like stable value funds and low cost institutional shares as well as investment education or advice services at no additional cost to you.
Pitfalls to Avoid: Since there are restrictions and possible penalties on withdrawing your money early, it’s a good idea to have some savings outside your retirement plan to cover emergencies and other short-term savings.