Getting a New Job – Some Tax Pointers
So you got a new job! Mazal tov! After the initial jumping up and down, realize that you are not done yet. Here are some issues to ponder before you finalize your pay package.
The Basics: Tax Brackets
People have asked me whether earning a little too much could get them pushed into a higher tax bracket, leaving them with less take-home pay. They wonder if it would therefore not be more profitable to earn somewhat less. The answer is no. You want to earn more money. Here is the mechanics of it: While it is true that as you make more money, you move into a higher tax bracket – meaning that you must pay a higher percentage of your income for taxes – it is only that portion of your income that exceeds the lower bracket limit that is subject to the higher tax. For example, when your taxable income goes over $70,000, your rate increases from 15% to 25%. Say you earn $80,000. Only $10,000, the amount of your income over $70,000, will be taxed at 25%. The first $70,000 remains at the 15% bracket. This is called graduated tax brackets and is fundamental to our income tax system. Without this concept, if a person’s income goes up by one dollar, it would cause his taxes to increase by thousands. This does not happen, but the rumor persists. So, if someone is offering you a raise, take it!
There are some rare cases where a small increase in income can have exaggerated effects on your tax liability. (I discussed this in an article last year called “Wacky Tax Laws.”) The good news is that one’s compensation can be partially tax-free. Let’s analyze some ways.
Pensions
We should all be saving for a rainy day, and the ultimate rainy day is retirement and old age. Our tax laws therefore encourage saving money for the golden years. This is called a pension plan. Money for pension funds can come from the employee or the employer, but the fund is usually structured so that both contribute. This common form of a pension is called a 401k. That is a fancy title for saving money in a bank or investment account that buys stocks or mutual funds. A mutual fund is an investment offering in which the brokerage buys many different stocks. You pay a price per share, and you get the benefit of diversification. This is better that investing in only one company’s stock, because if it performs poorly you are sunk.
The money in a 401k cannot be withdrawn until you are 60, but the advantage is that whatever money you put in is tax deferred. This means that it is deductible during your working years, and although you might have to pay income tax when you withdraw it, during retirement, your income is likely to be lower. The most important thing is to build up your nest egg, and then you won’t care about taxes.
To make it even better, the employer very often contributes money for you as well. This is called matching funds, which means that if the worker puts away $1,000, the boss will put in a second $1,000. However, the employer only has to contribute if you decide to participate. I have seen situations where employees do not want to participate, because they feel that they cannot afford it. This is a great loss.
Take this example: Imagine a worker who is in the 25% federal bracket. With a Maryland state tax rate of about 8%, this worker is now in the 33% tax bracket. (Remember, only the upper income is taxed at 33%, not all of the income.) If the employee puts $6,000 in his 401k, he will therefore save income taxes on that income. In the 33% bracket, that comes to $2,000. Now, since he saved $2,000 in taxes, the pension contribution of $6,000 really only cost him $4,000.
Now, let’s say the employer matches your $6,000. You will then have $12,000 in your fund, and it only cost you $4,000! That is amazing. When I see people who do not participate because they feel that they cannot afford the $4,000, I tell them that I consider that to be a disastrous financial mistake. You always want to put in the most allowed, in order to maximize the match. The pension plan might say that the employer will match 100% of your contribution, up to, say, 5% of your earnings. Therefore, if you make $100,000 and you put in $5,000, the boss will also put in $5,000. The boss will not exceed this $5,000 even if the employee does. (The maximum contribution allowed is $17,500 even more if you are over 50.) So, the worker should put away at least the 5%. This is called maxing the match and should be considered obligatory. If you feel that you cannot afford it, please do some serious budgeting number crunching.
Work Expenses
Sometimes employees have to spend money for their job: for instance, using their own car to travel. If the employee tries to deduct this expense, it will be only partially deductible, at best. However, they would be deductible to the employer in full. Your pay arrangement should therefore be structured so that the boss pays the expenses, and those amounts should not be part of your taxable pay. This is perfectible legal so long as the employee “accounts” to the employer for the expenses. This means keep good records and only getting reimbursed for the expenses you incurred and not more.
Let’s work the following example: Let us say that you earn $100,000 and reasonably expect to spend $5,000 on expenses. If the boss pays you for the expenses then your taxable income will only be $95,000. This will result in big savings on your taxes.
Medical Insurance
Employers can offer health insurance as a fringe benefit. A fringe benefit is something that benefits the worker but it is not taxable to the worker. It is, however, still tax deductible to the employer: a win-win situation. Under Obamacare, health insurance will be mandatory to an employer with more than 50 workers.
Cafeteria Plans
FSAs, also called cafeteria or “flex” spending plans or section-125 plans, allow you to set aside money to be used for out-of-pocket medical expenses (max $2,500) or daycare expenses (max $5,000). These expenses will also not be taxable income. The only issue here is that, if you set aside the money and you do not spend it, you will lose the money. Plan carefully and proceed with caution. (Actually, you can carry over $500 to the next year or receive an extension of two-and-a-half months to spend the money.)There are other fringe benefits that are less common. Read IRS publication 15-B.
Withholding Taxes
An employer is required to hold back some of your pay for taxes and send it to the government. This is called withholding. They must withhold three separate taxes: Social Security, federal, and state. I get a lot of questions on this. Bear in mind that if too much is withheld, you will get it refunded when you file your taxes.
Some people are allowed to request that no income taxes be withheld. This is true if they can state that they did not owe any taxes last year and do not expect to owe any this year. This is common when teenagers have summer jobs. This exemption is accomplished by filling out a line on the form W-4. Bear in mind that even those who are exempt from withholding will have to pay your half of the Social Security tax of 7.65%. That one cannot be avoided or refunded.
Many people have to fill out a long worksheet on the W-4, which can get complicated. Here is a common error: Imagine that a couple has several part-time jobs. Each job uses tax tables to determine taxes, and since each job offers relatively small pay, each employer “thinks” that no taxes are due. At the end of the year, however, when you add it all up, you will owe taxes and will then have to write a check, come April 15. If you have a lot of small jobs, you might have to request from the employer to take off extra taxes beyond what the tax tables require. If this is your situation, you should try to forecast the annual total income to see where you will be at tax filing time.
Independent Contractors
Sometimes you get paid but your boss does not take off any taxes. That means that you are not an employee at all but rather a contractor. You have to deal with your own taxes and send them in yourself. The good news is that any expenses you incur are fully deductible. Some clarification is needed regarding the Social Security tax, however. When you are an employee, your boss has to pay half of your Social Security taxes. Each worker is in essence earning an extra 7.65%. A contractor does not get this benefit, and will owe the whole 15.3% rate. Bear this in mind before agreeing on a pay rate.
Rabbi Berel Wein tells a story about his rebbe, who had a sign on his desk that read, “Vus zogt Got – But what does G-d say?”
A slightly different version of the same question has to be posed regarding independent contractors: “But what does the IRS say”? This is a big topic, but essentially, the IRS wants people to be treated like employees unless they are clearly working independently. There are 20 common legal tests to determine if a person is indeed independent. Make sure you clearly qualify before you take the risk of running afoul of the IRS. This is mostly a warning to the employer, who has the legal obligation to withhold taxes if the worker is deemed to be an employee.
Bear in mind that, when you ponder the above tax savings issues for employees, it might not be so clear if the employer is really saving any money by making someone an independent contractor. In any regard, playing it safe with the taxman should be the prime consideration.
Conclusion
As you can see there is a lot to ponder after you get a job offer to create a package that is advantageous to everyone.
Eli Pollock, CPA, can be reached at elipollock2@yahoo.com.
