Congratulations! If you just graduated from college, there’s a good chance that you’ll make more money in 2008 then you did in 2007.
You: That’s what they tell me.
In fact, you’ll also make quite a bit more money in 2009 than 2008.
You: How do you know that? You know my raise?
Nope, but in all likelihood, you’ll work less than eight months full-time in 2008. In 2009, you’ll work the whole year. So even if you don’t get a raise at all, your income should dramatically increase from 2007 to 2008 and again from 2008 to 2009.
You: That’s cool, I guess. But where’s the opportunity?
Tax-planning.
You: Sounds boring.
It is boring. You want excitement, go here. That doesn’t work, try visiting here. You want tips that can help you financially, keep reading.
You: Okay. Go ahead, bore me.
Last week, I told you how to determine how little you can withhold without owing the IRS any interest or penalties. If you are a recent graduate who will make dramatically more each year than the previous, you have a major opportunity to increase your net pay right from the outset.
You: Increase my net pay? Maybe this isn’t as boring as I thought.
You don’t want a big income tax refund, right?
You: Right. I don’t. We covered why an income tax is a bad idea earlier.
If you just complete Form W-4 without any thought, you’ll probably put in “1″ for the number of allowances (line 5). As a result, you’ll wind up with a big refund, since the amount withheld each paycheck assumes that you’ll earn your salary for 12 months. Since you’ll only earn that salary for a few months of 2008, too much tax will be withheld. That’s the first reason why you’ll want to increase your allowances to lower your withholdings.
You: Is there a second reason?
<Think game show voice-over man speaking:> In fact there is!
<Back to normal voice, whatever you might think that is:>
Since you only need to withhold the amount of your prior year’s tax (virtually nothing in 2007 if you were a full-time student), you can even further increase your allowances and thereby dramatically reduce your withholdings.
Increasing your net pay in this manner will allow you to get more money in your hands when you need it most, thanks to the start-up expenses of life including a security deposit, work clothes, and initial emergency fund savings. Just make sure you have enough around next April to pay the piper (should you actually owe the IRS). You can use this handy withholding calculator to help you calculate your allowances (designed to make it so that you neither owe much or get a big refund) or you can spend four days and use the one available at this site.
Figuring this all out is worth it. Personally, I put 10 allowances my first two years of working after graduate school, and still got refunds each year. Not as big as they would have been without adjusting my withholding, but having that money in my initial paychecks to use as needed definitely allowed me to save far more far earlier in my career than I otherwise would have been able to.
Start saving right away by being fiscally responsible. There’s never a better time to develop good, smart financial habits than today.
Let me know what you think and how this works out for you. . .
Tags: college graduates, Saving Strategies, tax withholdings
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Michael,
I have been a periodic reader of your blog lately (full-time reader when I was only working 40 hours weeks, but now its more like 80-90 weeks with a new job and graduate school decisions). I have essentially been doing this approach so far with my new job this year, but I was never able to actually find those simple answers to how much you need to have withheld to not be fined. Thank you so much for those simple suggestions, because I’m well aware that every little bit helps!
Thanks and I’m looking forward to more beneficial suggestions in the future!
-Jeremy
I too am a little confused. I don’t know if my case is rare, but amongst recent college grads, I have a lot of friends in the same situation. Michael be our guide!
My boss pays me in full every week without taking taxes. Does this mean that I work for her company or am I in essence my own company and she my client? She claims me at the end of the year and I in turn owe A LOT of taxes. I fully understand that it’s better to get more in your paycheck since you get the interest, but is it a good thing or a bad thing that she claims me at the end of the year and pays me in full the rest of the year? No I obviously do not get any benefits…
Am I in a good situation or a bad one?!?!!
Thanks Michael!
@ Jeremy: Thanks! Glad you found the answers you needed here. Hope you’re loving your job as much as you’re working. Keep visiting/commenting when you’re able.
@ M.C.: Without commenting on whether what your boss is doing is proper (there’s pages and pages of material out there about what constitutes an employee vs. an independent contractor relationship), I’d say you’re partly in a bad situation and partly in a good situation.
The bad news is that you must pay both halves of the payroll (Social Security and Medicare) tax instead of your employer paying half. Assuming your compensation from your boss is less than $102,000 in 2008, you’re paying 15.3% instead of 7.6% in payroll taxes. Multiply that by your compensation and you’ll likely see that’s quite a chunk of change that’s coming out of your pocket.
The good news is that – as an indepdendent contractor – many more normal business expesnes are deductible than would be if you were categorized as an employee. This is because you must itemize (and meet other hurdles) to benefit from unreimbursed business expenses you incur as an employee whereas an independent contractor can pretty much deduct them on Schedule C.
Please note that just because nothing is withheld during the year does NOT mean you do not have to pay anything during the year. (Said without the double negative: it’s quite likely you need to be paying taxes before next April.) If you expect to owe tax, you’re supposed to make estimated payments each quarter or you may owe interest and penalties (for under-paying during the year) come next April. I don’t know your specifics, of course, but note that it’s possible that the only reason you haven’t got burned by your not paying quarterly thus far was because you benefited from a low prior year tax (see main post above). That may not continue in perpetuity.
See what happens when you ask a good question?
Consider looking at http://www.irs.gov too.