Ch2. Tax Saving Guide — Payroll, W-4 Withholding, and Salary-Based Tax Reduction

How Your Paycheck Turns Into Taxes

Before you can plan, you need to see exactly which taxes come out of each paycheck and why.

Gross Pay
  − Federal Income Tax Withholding
  − State / Local Income Tax Withholding
  − Social Security Tax (6.2%, up to $168,600 wage base in 2024)
  − Medicare Tax (1.45%; +0.9% on wages above $200K single / $250K MFJ)
  − 401(k) / 403(b) Pre-Tax Contributions
  − HSA / FSA Pre-Tax Contributions
  − Health / Dental / Vision Insurance Premiums (pre-tax via §125 plan)
= Net Pay (take-home)

Every pre-tax item reduces the base on which federal and state income tax is computed. Social Security and Medicare (FICA) apply to gross wages before most pre-tax deductions, but traditional 401(k) contributions do reduce FICA in some plans — check with your employer.

The W-4: Controlling How Much Is Withheld

Your Form W-4 (Employee’s Withholding Certificate) tells your employer how much federal income tax to withhold. Getting this right prevents both a large balance due at filing and an unnecessarily large refund (which is an interest-free loan to the government).

Why the 2020 redesign matters

The 2020 W-4 eliminated withholding allowances. It now asks directly for:

Other income not subject to withholding (side gigs, investments)
Deductions you expect to claim beyond the standard deduction
Credits you expect to claim (Child Tax Credit, etc.)
Extra withholding per pay period

Who should update their W-4

Update your W-4 when any of these occur:
✓ You marry or divorce
✓ A dependent is born, adopted, or ages out
✓ You take on a second job (or your spouse starts working)
✓ You receive a large bonus or investment income
✓ You retired mid-year or had a job gap
✓ Last year you owed a large balance or got a large refund

IRS Withholding Estimator

Use the IRS Tax Withholding Estimator (IRS.gov) to calculate the exact dollar amounts to enter on Steps 3 and 4 of the W-4. Update after any major life event.

The Most Powerful Tool: Pre-Tax Retirement Contributions

Traditional 401(k) and 403(b) contributions are deducted from your paycheck before federal and state income tax is calculated. This is the single largest tax lever for most salaried employees.

2024 Contribution Limits:
- Under age 50: $23,000
- Age 50 or older: $30,500 (with $7,500 catch-up)

Real dollar impact

Gross salary:             $90,000
401(k) contribution:     −$23,000
Taxable income:           $67,000

Without 401(k):
  Taxable income: $90,000 − $14,600 standard deduction = $75,400
  Tax: approximately $12,908

With 401(k):
  Taxable income: $67,000 − $14,600 = $52,400
  Tax: approximately $8,908

Annual tax saving: ~$4,000 (at combined 22% marginal rate)

Traditional vs. Roth 401(k)

	Traditional 401(k)	Roth 401(k)
Contribution timing	Pre-tax (deducted now)	After-tax
Tax reduction today	Yes	No
Withdrawals in retirement	Taxed as ordinary income	Tax-free
Best when	Current rate > expected retirement rate	Current rate < expected retirement rate

General rule: If you expect to be in a higher bracket in retirement, lean toward Roth. If you expect a lower bracket, lean traditional.

Employer Match — The Guaranteed Return

Every employer match dollar is a 100% immediate return on your contribution. Always contribute at least enough to capture the full match before any other investment decision.

Example:
Employer matches 100% of first 4% of salary.
Salary: $80,000

Minimum to capture full match:
  $80,000 × 4% = $3,200 your contribution
  $3,200 employer match (free money)
  Total retirement account increase: $6,400

Effective return on your $3,200: 100% — before any market growth.

Health Savings Account (HSA) — Triple Tax Advantage

If you are enrolled in a High-Deductible Health Plan (HDHP), you can contribute to an HSA. No other account in the tax code offers the same combination.

2024 HSA Contribution Limits:
  Individual coverage: $4,150
  Family coverage:     $8,300
  Age 55+ catch-up:   +$1,000

The Triple Advantage:
1. Contributions are tax-deductible (or pre-tax if payroll-deducted)
2. Growth (interest, dividends, capital gains) is tax-free
3. Withdrawals for qualified medical expenses are tax-free

No "use it or lose it": HSA funds roll over every year indefinitely.
After age 65, non-medical withdrawals are taxed as ordinary income (same as a Traditional IRA).

HSA as a long-term strategy

You can invest HSA funds in mutual funds or ETFs and let them compound for decades. Many high-earners “invest and never touch” the HSA, paying medical bills out-of-pocket and preserving the triple-tax-free balance for retirement healthcare.

Flexible Spending Account (FSA)

FSAs come in two types: Healthcare FSA and Dependent Care FSA.

2024 Limits:
  Healthcare FSA:      $3,200
  Dependent Care FSA:  $5,000 per household ($2,500 if married filing separately)

Healthcare FSA — use for:
  Medical, dental, vision expenses not covered by insurance
  Over-the-counter drugs and feminine hygiene products (as of 2020)

Dependent Care FSA — use for:
  Daycare, preschool, after-school care for children under 13
  Adult day-care for a dependent unable to care for themselves

"Use it or lose it" rule: Most plans allow a $640 rollover or 2.5-month grace period.
Plan contributions carefully to avoid forfeiture.

Tax saving calculation

Dependent Care FSA: $5,000
Your marginal rate: 22%
Tax saving: $5,000 × 22% = $1,100 (federal alone)
Add FICA savings (~7.65%): $5,000 × 7.65% = $383
Total saving: ~$1,483 — just by routing daycare through FSA.

Commuter Benefits

Employer-sponsored commuter accounts let you pay for transit and parking pre-tax.

2024 Monthly Pre-Tax Limits:
  Transit / Vanpool: $315/month ($3,780/year)
  Parking:           $315/month ($3,780/year)

At a 22% marginal rate + 7.65% FICA:
  $3,780 transit benefit saves:
  $3,780 × (22% + 7.65%) = $3,780 × 29.65% ≈ $1,121/year

Key Above-the-Line Deductions for Employees

These reduce AGI and are available even if you take the standard deduction.

Student Loan Interest Deduction:
  Up to $2,500 deductible
  Phases out: $80,000–$95,000 (single), $165,000–$195,000 (MFJ) — 2024

Traditional IRA Deduction:
  2024 limit: $7,000 ($8,000 if age 50+)
  Full deduction if neither spouse has a workplace plan.
  Phases out if covered by a workplace plan:
    Single: $77,000–$87,000
    MFJ (covered spouse): $123,000–$143,000

Alimony (pre-2019 divorce agreements):
  Still deductible as above-the-line for agreements finalized before 1/1/2019

Health Insurance Premiums Through Your Employer

If your employer offers health coverage under a Section 125 cafeteria plan, your premium contributions are:

Excluded from federal income tax
Excluded from FICA taxes
(Usually) excluded from state income tax

Example: employer plan premium = $3,600/year
Tax saving (22% + 7.65%): $3,600 × 29.65% ≈ $1,067
This saving happens automatically through payroll — nothing to file.

Self-employed individuals can deduct 100% of health insurance premiums as an above-the-line deduction (Schedule 1, line 17).

Year-End Checklist for Salaried Employees

By October:
□ Check year-to-date 401(k) contributions; top up if below limit
□ Confirm FSA balance — estimate remaining eligible expenses before year-end

November–December:
□ Verify HSA contributions are on track to the limit
□ Review commuter benefit elections for the new plan year
□ Request a W-4 review if your income or family changed this year
□ Consider bunching deductible expenses (medical, charitable) if close to itemizing

January (after year-end):
□ Gather all W-2s, 1099s, and deduction receipts
□ Confirm last year's FSA was fully used; note rollover amount
□ File FAFSA if applicable (uses prior-prior year income)
□ File Form 1040 (deadline April 15; extension to October 15 available)

Summary Table

Tool	2024 Limit	Tax Reduction Mechanism
401(k) Traditional	$23,000 ($ 30,500 age 50+)	Reduces federal + state taxable income
Traditional IRA	$7,000 ($ 8,000 age 50+)	Above-the-line deduction (income limits)
HSA	$4,150 /$ 8,300	Pre-tax, tax-free growth, tax-free medical withdrawals
Healthcare FSA	$3,200	Pre-tax; FICA savings too
Dependent Care FSA	$5,000	Pre-tax; FICA savings too
Commuter Benefits	$315/mo transit +$ 315/mo parking	Pre-tax; FICA savings too
Employer Health Premium	N/A	Excluded from income and FICA

Practice Quiz

Q1. You contribute $23,000 to your traditional 401(k). Your marginal federal rate is 22%. What is your approximate federal tax saving?

$2,300
$5,060
$4,600
$3,680

Answer: 2 — $23,000 × 22% =$ 5,060. State income tax savings would be additional.

Q2. Your employer matches 100% of the first 3% of your $70,000 salary in your 401(k). What is the minimum contribution to capture the full match?

$700
$2,100
$3,500
$4,200

Answer: 2 — $70,000 × 3% =$ 2,100. This unlocks a matching $2,100 from your employer.

Q3. Which of the following is NOT a benefit of an HSA compared to a Healthcare FSA?

Funds roll over indefinitely (no use-it-or-lose-it rule)
Contributions can be invested in stocks or mutual funds
Withdrawals for non-medical expenses are always tax-free
Both employer and employee can contribute

Answer: 3 — Non-medical HSA withdrawals before age 65 are taxed as ordinary income AND subject to a 20% penalty. After age 65 the penalty disappears but tax still applies.

Q4. Which of the following W-4 changes would most likely result in too little withholding (potentially causing a balance due)?

Adding a newborn dependent to Step 3
Getting a second job and not adjusting Step 2
Requesting extra withholding in Step 4(c)
Filing as Married Filing Jointly after getting married

Answer: 2 — A second job effectively moves you into a higher bracket, but the default withholding tables for each job assume it is your only job, resulting in under-withholding.

Q5. You have $4,000 remaining in your Healthcare FSA on November 1. Your plan has no rollover provision. What is the smartest action?

Do nothing; the money is already gone
Schedule dental work, vision appointments, or other qualified expenses before December 31
Transfer the balance to a different account
Request a refund from your FSA administrator

Answer: 2 — FSA funds used for qualified medical expenses before year-end are fully tax-free. Unused amounts are generally forfeited. Schedule any planned or needed care before the deadline.