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Empowering your money

How to get the most out of your paycheck

At a glance:

Your paycheck is a potentially valuable resource for many reasons beyond simply the money you've earned through working for your employer.

It's important to not only handle your paycheck responsibly by paying the correct amount of taxes but also by avoiding short-term loans such as payday loans.

By making the most of your paycheck, you can stretch the dollars you earn to cover more of your out-of-pocket expenses and have some money left over to save for future goals.

What to know about payroll taxes

When you get your paycheck, it can seem like most of it is eaten by various taxes. You probably feel a lot like entertainer Arthur Godfrey, who said, "I am proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money."

Types of payroll taxes

Every employee has taxes withheld from their paycheck; some may have more taxes than others, depending on where they live. Here are the types of taxes that are typically withheld from a paycheck:

  • Federal income

  • Social Security

  • Medicare

  • State income

  • Local income

If you live in Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming, you will pay no state income taxes. In Tennessee or New Hampshire, you will pay nearly none.

Federal income taxes, and state and local income taxes where they are levied, are withheld from your paycheck as a payment toward your yearly income tax obligation.

Social Security and Medicare taxes are contributions toward the benefits you will ultimately receive from those programs when you retire. Social Security takes 6.2% of your wages, up to a certain annual amount, while Medicare takes 1.45% of all wages, or 2.35% for those earning over certain high wage amounts.

… and don't forget certain fees

Payroll cards bear some mention, even though they are not tax-related. If you receive your wages via a payroll card—a debit card that is loaded up with your wages—instead of a traditional check or direct deposit, you should be aware that there may be fees involved for accessing your money.

There may be fees to get your balance, for calling customer service, and/or for actually using the card.

How using direct deposit can leave more in your paycheck

Direct deposit involves having the money you earn in your paycheck sent directly to your account at a bank, savings and loan, or credit union by your employer.

Instead of giving you a paper check, your employer provides some kind of notification of the amount you were paid and what was withheld, either in paper or electronic form.

How direct deposit works

Many employers offer direct deposit. It saves employers money because they don't have to pay to have paper checks issued, and it is safer for you because there is no risk of having a check lost or stolen before it is deposited into a bank account.

If you use direct deposit instead of getting a paper check, every pay period your employer will electronically transfer the amount of money you are paid directly into your bank account. That money may be available for you to spend the day it is deposited—payday—or the day afterward.

Advantages of direct deposit

Direct deposit offers many advantages that can help you make the most of your paycheck. If you work odd hours or don't live close to your financial institution, you can save the time and money that it would have taken you to drive to the bank.

If you are sick, off or on vacation on payday, your check will be deposited into your bank account as usual and you won't have to wait to get the funds until you are back at work. In addition, if you have direct deposit, you will never have to pay a check-cashing fee if you can't get to the bank and need cash.

There are many other advantages of direct deposit. You can set up automatic transfers from your bank account so that bills are paid on time from the funds that were deposited, transfer money to savings accounts, and make extra payments on debts such as credit cards and car loans.

If you deposit a paper check, the bank may place a hold on those funds, and they may not immediately be available to withdraw or use to cover checks you write or charges on your debit card.

In contrast, funds from direct deposit are usually available more quickly, so there is less likelihood that you will bounce a check or a charge you make on your debit card.

That can save you money in bounced check fees and the hassle of having to wait until your check clears and funds are available to pay bills or make withdrawals.

Many banks, credit unions, and savings and loans offer small percentage discounts on loan rates to customers who have their paychecks deposited directly. Another benefit may be a free checking account.

One downside is that you will have to change your direct deposit information at your employer if you decide to change banks. You may also need to utilize your debit card and ATM withdrawals more often to turn your direct deposit into cash.

Payday loans: What you need to know

Payday lenders offer small loans designed to help tide you over to the next paycheck. These loans are set up to be paid back by the next paycheck, but many low-income borrowers need the funds for the next paycheck to pay their bills, and end up taking out another payday loan.

Payday loans have very high interest rates—as much as 400 percent on an average annual percentage rate according to the Consumer Financial Protection Bureau. The lender may also charge administrative and loan fees, adding to the cost of the payday loan.

The average payday loan borrower ends up in debt for more than six months with an average of nine payday loan transactions, according to the Center for Responsible Lending. More than 12 million Americans every year take out at least one payday loan.

How payday loans work

Many people end up with a payday loan due to a relatively minor financial emergency, such as a car repair or a medical bill. The high interest rates on a payday loan make it very difficult for borrowers to repay the loan when it comes due—at the next paycheck—so they end up borrowing more money and getting more deeply in debt, setting up a cycle of debt that is very difficult to break.

The fees and interest rates charged as part of the payday loan are deducted from the amount received by the borrower, but the full amount is due on the borrower's next payday. For a low income borrower, it can be very difficult to not only repay the loan and the fees from the loan, but also to have enough money to pay the upcoming bills that would be covered by the next paycheck, which now has to be used to repay the payday loan.

That's why many borrowers end up having to take out another loan and pay even more in interest and fees.

In this Aug. 19, 2009 photo, Veronica McGregor, left, and her daughter, Katie McGregor, 16, look over pay stubs and other financial information pertaining to Katie's first summer job as a swimming teacher at Hawthorne city pool, at their home in Redondo Beach, Calif. (AP Photo/Damian Dovarganes)
In this Aug. 19, 2009 photo, Veronica McGregor, left, and her daughter, Katie McGregor, 16, look over pay stubs and other financial information pertaining to Katie's first summer job as a swimming teacher at Hawthorne city pool, at their home in Redondo Beach, Calif. (AP Photo/Damian Dovarganes)

The costs of payday lending

For example, if you took a $350 payday loan, that loan typically would include $60 in fees. So you would receive $290 instead of the $350 because the fees are deducted from the loan.

If you can't repay the $350 loan when it is due—in a week or two when you next get paid—you would either need to pay another $60 in interest and fees to keep that loan outstanding or take out another $350 payday loan with $60 in fees.

That cycle can easily continue, with you paying $60 in fees every week or every other week because you can't pay the original $350 back.

If it took you six weeks to pay that amount back, and you were then able to stop from taking out another payday loan, that would be $360 in fees to borrow $350. You would pay more in fees than you actually borrowed.

And if the loan went on longer because you couldn't afford to pay it off, those fees would grow. If you kept rolling over the loan for 10 weeks, you would end up paying $600 in fees.

Alternatives to Payday Loans

There are alternatives to payday loans if you are in a financial crunch. Many credit unions offer small emergency loans at interest rates much lower than payday lenders. Some banks also have similar programs. You may also be able to get a cash advance from a credit card. While those interest rates may be high, they are not as high as that of a payday loan. Or perhaps you could borrow money from a family member or friend.

If your problem is that you are in too much debt or overwhelmed by bills, credit counseling can help. An accredited non-profit credit counselor can help you work out a payment plan with your creditors to get you on a sustainable financial footing.

Pay yourself first: Here’s how

If you're like many people, you want to save money for yourself, but when it comes time to set aside money from your paycheck, you find that there's nothing left over.

You've paid the rent, the bills, and the leisure. And that makes it impossible to save. So why not pay yourself first rather than last?

What does it mean to pay yourself first?

Paying yourself first means setting aside money for savings before you pay any of your bills or other expenses. In other words, the first "bill" you pay each month should be to yourself. This forces some discipline onto your spending. You may find that you have to rethink your money priorities.

You may have to do without some things, or at least change how you do them. Paying yourself is about making regular and consistent contributions toward some kind of goal, such as retirement. Although some might see it as a kind of deprivation, it is more about freeing yourself so you can afford other opportunities in life.

To pay yourself first is to make yourself more important than your bills. And it's not about being selfish—as your wealth grows, you will find yourself in a better position to help others.

An example

Just how much can you build by paying yourself first? It varies. Here's an example: saving $20 a month and depositing it monthly for five years at 2% will yield about $1,262. Taking out $20 a month as a 28-year-old and putting it into an account earning 5% per year will grow to over $24,000 by age 65.

Can you afford to forego a few small luxuries a month for this? The point here is that putting away even small amounts will add up over time. The earlier you start, the more it will grow. Every little bit helps.

And you could increase your contributions as you grew older and more disciplined, and you could choose investments that grew much more than 5%.

How it relates to retirement

Paying yourself first is important to retirement planning because you will need to save regularly over the course of many years. You want to make it a habit. If your employer offers a retirement plan, you can enroll in it and contribute regularly; if it matches your contributions, that's like getting free money.

How to do it

The most painless way to pay yourself first is to set up an automatic savings program. You'll never know it's gone, and you'll adjust accordingly. Consider having regularly scheduled withdrawals made from an existing account (e.g., the checking account where your paycheck is deposited) and transferred into a retirement account.

Generally, any financial services institution that offers savings or investment accounts will offer an automatic savings plan. Most retirement accounts will have the option to link to your savings or checking account to withdraw funds regularly.

If you find that you can't make ends meet by paying yourself first, look for expenses you can cut or find ways to raise the needed money. An honest and thorough look at your spending should provide some clues.

How to save money with pre-tax accounts

If your employer offers specialized accounts such as flexible spending accounts or health savings accounts, you can save money to pay for childcare, healthcare and commuting expenses.

You can specify that a certain amount of money will be deducted from your paycheck to be put into an account to pay for childcare, healthcare or even public transportation or parking expenses associated with your employment.

Types of pre-tax accounts

To be eligible to contribute to one of these types of accounts, your employer must offer them. So check with your employer first to see which accounts are available and how to go about setting one up. The most commonly available accounts are healthcare flexible spending accounts, dependent care flexible spending accounts, and health savings accounts.

With any of these types of accounts, the money that you set aside is used to pay for specific expenses, typically via a debit card that is issued specifically for that purpose. Because funds are taken out of your paycheck before taxes, that money goes farther than if you paid for those funds without the benefit of one of these specific types of spending accounts.

How Pre-Tax Accounts Can Help

For example, if you needed dental work that cost $1,000, it could be advantageous to utilize pre-tax dollars from an employer healthcare flexible spending account or a health savings account as opposed to the after-tax dollars that may be sitting in your checking account for example.

While the cost of the dental work will not change, the amount of taxes you pay in the process would. These types of health care savings accounts pay for a wide variety of medical expenses, including prescriptions, doctor's visits, hospitalizations, surgery, medical tests, dental work and other medical procedures.

The same logic holds true for childcare expenses if your employer if your offers a dependent care flexible spending account. The amount of taxes you pay when dealing with these expenses could be less than they would be if you simply utilized your after-tax cash account.

You don't have to save the entire amount of your medical or childcare bills, just whatever you want to or can afford. But you can save a significant amount of money by using these types of accounts.

The federal government allows employers to also offer a transportation flexible savings account, which can be used to pay for qualified transportation costs such as public transportation or parking costs.

How much can you save through pre-tax accounts?

There are limits on how much you can save through these various types of accounts, and different rules apply to them. You can only open a health savings account if you have a high-deductible health insurance plan.

An individual can save $3,550 a year in 2020 for this type of account, while a family can save up to $7,100. The funds roll over year-to-year.

That's not true for a healthcare flexible spending account, where you generally must spend the money in the account by the end of the year. The IRS now allows for two exceptions to this rule of which your employer may choose to elect one: you may roll over $500 from one year to the next or the money must be spent by the end of a two-and-a-half-month grace period at the end of the year.

For 2020, contributions to a healthcare flexible spending account are limited to $2,750 a year and to $5,000 a year for a dependent care flexible spending account. For a transportation spending account, the limit is $270 a month for qualified commuting expenses and $270 a month for qualified parking expenses.

How to evaluate banks and credit unions

What parts of the banking experience are most important to you? To some people, customer service and convenience are everything.

To others, saving money on fees is everything. Still others care mostly about the reputation of the institution, while others are motivated most by the services that it offers. Everyone is different.

If you haven't given it much thought, consider evaluating your own bank or credit union and asking yourself whether it is what you really want. If you do not have one, then look at the features and services listed below and ask yourself which of them matter most to you.

Features

Here are the typical features considered:

  • Convenience. Are there branches near you? Is there online access? Online bill pay? Do the hours fit your schedule?

  • Interest or dividend rate. One of the most considered features is what you can expect to earn. What interest or dividend rates are being offered? (Interest is paid on bank accounts, while dividends are paid on credit union accounts).

    • Because credit unions are non-profit, they often can afford to pay slightly higher rates than banks. Look for the "annual percentage yield," which takes compounding of earnings into account.

    • Limits. What limits are imposed on your account? Is the number of transactions limited, for example? Do you have to wait a certain length of time before you can withdraw your funds after you've deposited them?

    • FDIC or NCUA membership. If a bank is a member of the Federal Deposit Insurance Corporation, or if a credit union is a member of the National Credit Union Association, your savings will be insured for up to $250,000.

    • Bank size. Larger banks tend to offer more services and options, while smaller banks tend to offer (as a general rule) more attentive customer service.

    • Minimum deposit. What is the minimum deposit required to open an account?

    • Fees. Fees are often the make-or-break feature of an account. Compare the fees at different institutions.

    • Incentives for keeping other accounts under the same provider.

    Services

    Generally, the larger institutions offer more services than the smaller ones. They usually have in-house staff to tend to such services as investments and financial planning.

    Also, as a rule, banks offer more services than credit unions—though size may overrule this.

    Services include the following (not all institutions offer all of them):

    • Online banking, including online bill paying

    • ATMs

    • Direct deposit

    • Credit cards

    • Debit cards

    • Telephone banking

    • Canceled checks

    • Loans, including mortgages, business loans, and auto loans

    • Overdraft protection

    • Investments—stocks, bonds, mutual funds, money markets, etc.

    • Foreign currencies

    • Financial planning services

    • Financial planning software and budgeting tools

    • Estate planning services

    • Retirement accounts

    • Retirement planning services

    • Health savings accounts

    • Business accounts

    • Business services

    • Variations on existing accounts (e.g., vacation savings accounts)

    • Money markets

    • Copies of previous monthly statements

    • Traveler's checks

    • Mortgage refinancing

    • Safe deposit boxes

    • Cashier's checks

    • Money orders

    • Wire transfers

    • Educational programs

    • Automatic savings and investment options

    Summary of making the most of your paycheck

    We've shared some thoughts about ways to stretch your paycheck a little bit farther. By implementing some of the tips we've provided, you may be able to add to your savings, use tax-free spending accounts to pay for some expenses, and avoid budget-busting traps like payday loans.

    You could establish better savings habits and experience less stress around finances.

    Now that you realize all the different ways that you can make the most of your paycheck, we'd like to encourage you to take a concrete step to make that a reality in your financial life.

    Practical ideas you can start with today

    • Contact your employer to see if it can have your paycheck deposited directly into your bank or credit union account.

    • Review your W-4 to see if you need to adjust your withholding so you don't get a large refund but have more of what you make available for budgeting every pay period.

    This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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