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.
Flexible Spending Accounts (FSAs)
Tax Benefits: FSAs combine the best of pre-tax and Roth contributions since both the contributions and withdrawals are tax-free if used for qualified medical and dependent care expenses. That means if you’re in the 25% tax bracket, it’s like having a 25% discount on these areas of your budget.
Pitfalls to Avoid: Medications without a prescription are no longer eligible (except insulin). Whatever you don’t use by the end of the year, you lose so don’t contribute more than you’re pretty sure you’ll spend. If you do end up with some extra money at the end of the year, you can use it to stock up on things like prescription drugs and contact lenses.
Health Savings Accounts (HSAs)
Tax Benefits: Like FSAs, HSAs are tax-free on both contributions and withdrawals for qualified medical expenses. (They’re also free of FICA tax if part of a cafeteria plan but not if you make a post-payroll deposit into an HSA.) Unlike FSAs, you can roll over any unused amounts to future years and they can eventually be withdrawn for any purpose penalty-free after age 65. This can make them a hybrid health/retirement savings account and given the high probability of health expenses in retirement, you may even want to invest the money and let it grow tax-free for that purpose.
Pitfalls to Avoid: The penalty for non-qualified withdrawals has recently been increased to 20%, which is higher than the 10% early withdrawal penalty from retirement accounts, so this should be among the last money you touch for non-health related expenses.
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Employee Stock Purchase Plans (ESPP)
Discounts: Your employer may provide the opportunity to purchase company stock at a discount of as much as 15% from typically the lower of the stock price at the beginning and at the end of a given offering period. This blog post illustrates just how good of a deal this can be and argues that you should purchase the maximum number of shares allowed as long as you can sell them right after the purchase period.
Pitfalls to Avoid: Be careful of having too much of your portfolio in any one stock, especially if it’s your employer. No matter how safe your company may seem, you never know what can happen and the last thing you want is to lose a significant portion of your assets at the same time as you lose your job. There are also some tax pitfalls. If it’s a non-qualified plan, you’ll have to pay ordinary income tax on the discount when you purchase the shares. If it’s qualified, you won’t pay the tax when you purchase the shares but you’ll have to hold them an extra year to qualify for the lower capital gains rate on the growth.
Group Insurance Premiums
Group Rates: You can get group rates with no or limited underwriting on certain types of policies such as life, disability, and long term care for you and possibly family members as well.
Pitfalls to Avoid: Be sure to comparison shop since you may be better off with an individual policy, especially if you’re in decent health. Your policy may also not be as customized as you’d like and may not be portable, which means you would have to get a new policy after you leave your employer based on your health at that time. If your health deteriorates, that could leave you uninsurable or having to pay much higher rates.
Savings Bond Payroll Deduction Plans
Competitive Risk-Free Rates: Through this program, you can purchase US Government Series I Savings Bonds, which are fully-backed by the federal government, do not fluctuate in value, adjust with inflation, and are currently paying a 2.2% tax-deferred. The interest may also be tax-free for qualified education expenses.
Pitfalls to Avoid: You can’t cash out the bonds within the first 6 months and you lose 3 months of interest if you cash them out in the first 5 years.
529 Payroll Deduction Plans
Tax Benefits: The earnings grow tax-free if used for qualified education expenses.
Pitfalls to Avoid: You may have to pay a tax plus a 10% penalty if you withdraw the money for something else. In addition, you’ll want to make sure your retirement and other important goals are on track before saving for education since financial aid is available.
Of course, one benefit all of these deductions share is the convenience of being on auto-pilot. But since they tend to be out of sight and hence out of mind, this can also easily be a source of missed opportunity. The good news is that this inertia can be made to work in your favor. By taking just a little bit of time upfront to make sure you’re making the most use of them, you can reduce your taxes, build your wealth, and insure against catastrophe before you even have a chance to waste your paycheck on something else.