Deductions

When you start your job, typically you are given a W-4 form and based on what you fill out there, your take out every month is decided. On the W-4 form, there is a column called "Deductions". Normally most of the people select 1 for themselves and depending on how many dependents they add so many deductions. For example if you are married, you select 2 deductions. But I did not understand the real meaning of these deductions. Here is the explanation:

Let us say you make $3000 every paycheck before taxes. if you have claimed 1 deductions, let us say you take home $2500 after taxes. That means you are paying $500 every paycheck. That means you are paying $13000 in taxes per year. Now your yearly wages are $78,000 (3000*26).

If you look at the tax tables and for the $78,000 tax bracket let us say you have to pay $10,000 in taxes. That means you have paid $3000 extra in taxes. So when you file your taxes you will get a refund of $3000. Some people like it this way. They want to make sure they do not have to pay the government and they like a refund. They jump in joy when they get the refund as if the government has distributed free sweets.

Actually there is nothing to jump about. It is your money that you got back. You had given a interest free loan of $3000 to the government and you are getting it back. What happens if you increased your deductions from 1 to 2. Then instead of paying $13,000 in taxes, you would probably pay $11,500 in taxes per year. Your goal should be to get close to $10,000 so that you break-even. The extra money that you get, you can put in your savings account or a CD and earn interest instead of giving an interest free loan to the government.

YOUR GOAL SHOULD BE TO BREAK-EVEN. So while filling out your W-4 forms, do this calculations and fill out appropriate deductions so that you can break-even with the amount of tax you are supposed to pay for your wages. If you think you are paying more now, you can change your W-4 anytime. I thought this information would be useful.