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Should I change my W-4 to make ends meet?

With costs rising and paychecks flat, readers are looking for ways to make ends meet.  The Answer Desk, by John W. Schoen.
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With costs rising and paychecks flat, readers are looking for ways to make ends meet. Sandra is thinking about cutting back on withholding tax to give herself a raise. And Karen is trying to come up with a budget that lets her save for retirement.

Is it risky to go exempt for a couple of months on your payroll so that you can get all of your money (for) a week, just to make ends meet?
Sandra, Address withheld

With real wages actually falling (after adjusting for inflation) and food and energy prices rising, a lot of paychecks just aren’t going far enough. If you need to stretch, it’s a lot easier to have less tax taken out of your weekly paycheck than it is to get an actual raise.

The problem is that you’re going to owe that tax in April — no matter how much you choose to have withheld. If you don’t expect a year-end bonus — or some other windfall to help you cover that tax bill next April — all you’re doing is postponing the pain.

If you undershoot too far, you may also end up getting hit with a penalty. The rule is you have to have enough withheld (or pay estimated tax) to cover at least 90 percent of the tax you owe. Like many rules, there’s an exception: If you get a raise this year, and the tax withheld is 100 percent of what you owed last year, you’re off the hook. (And there are special rules for farmers and fisherman, but we’ll leave that for another answer.)

On the other hand, if you got a refund this year (not the special tax rebate check — an actual refund from paying too much tax last year), you may be able to give yourself that withholding raise and still have enough to cover your tax bill in April.

The only way to know is to get a copy of IRS Form W-4 and fill out the worksheet on page 2. You’ll see at the top of the page, it asks for your itemized deductions, which is where you’ll fill in the amounts for qualified interest payments.

Unfortunately, like everything else about IRS math, there’s a fair amount of “voodoo economics” in the formulas used to calculate these withholdings. Even after filling out the worksheet, your final tax bill may end up over- or undershooting what you’ve had withheld.

If you earn a steady paycheck, you could also try estimating what you’ll have earned by the end of the year, see how much you’ll owe based on the 2007 tax rates, and then adjust your withholding accordingly. This is also a little risky: The new tables for 2008 will be different. But if your salary and deductions haven’t changed much, you’ll be close.

I’m looking for a personal budget for young adults. Is there a “pie chart” that shows percentages for the daily life expenses that still allows retirement saving?
Karen, Terrebonne, Oregon

Congratulations: Just using the word “budget” is the first big step in getting expenses under control.

Getting serious about budgeting also assumes that you know where your money is going. If your money management consists of trying to cut back on how much you take out of the ATM machine each visit, try using a credit card so you’ll have a record of where your money’s going. Better still: Keep a detailed log for a month and then break down your spending by categories. Some people are surprised to learn just how much their actual spending habits differ from their budget.

Everyone’s different, so it’s hard to describe a “typical” budget. For one thing, the cost of living varies greatly from one part of the country to another. And each household is different: Some twenty-somethings are still working part-time and going to college, others are getting married and settling down to start a family. But it might help to look at where the “average” U.S. consumer in that age group spends their paycheck. The Bureau of Labor Statistics keeps detailed data on how we spend our money, broken down by age, income, education, region, you name it.

So let’s look at the Under 25s. About 20 percent of this group owns a home, the rest are renters. Seventy percent own or lease a car. The typical Under 25 “consumer unit” consisted of two people and earned $28,535 after taxes.

The biggest bill ($494 a month) goes to housing, which works out to about 21 percent of after-tax income. This is also the biggest wildcard in your budget, depending on where you live. Apartment dwellers in high-cost cities will likely devote a bigger percentage of their budget to housing. You can also expect to pay more for utilities if you live in a cold weather state.

Transportation is the next biggest expense ($472 a month) which eats up another 20 percent of your paycheck. That includes the cost of buying a car, keeping it repaired and filling it with gas. Gas prices have gone up since the 2006 data was collected; two years ago gasoline accounted for about 6 percent of the Under 25s budget.

Food eats up another 14 percent of our typical budget; about half ($162 a month) went to groceries and the other half ($164 a month) went for dining out. Figure another 3 percent ($63 a month) for alcohol and tobacco.

The next biggest category is “personal insurance and pensions” ($191 a month), or 8 percent of spending. But that’s a little misleading because it includes your contributions to Social Security, which most people think of as part of their taxes. Still, consider that part of your retirement savings.

After that, the bills start to lighten up a little. About 6 percent ($148 a month) goes for utilities, including $60 a month for the phone bill. Clothing accounts for 5 percent ($122 a month); so does entertainment ($112 a month) and education ($109 a month), which include books and magazines. Home furnishings and appliances ($82 a month) makes up 3 percent; so does health care costs ($59 percent.) Other household costs ($56 a month) and contributions ($53 a month) take up 2 percent each. Personal care products and services ($29 a month) and miscellaneous ($32) each account for 1 percent of the budget.

Alas, the tables don’t break out a category called “saving for retirement,” but the total spending for this age group comes to $28,181 a year. Based on after tax income of $28,535, our typical Under 25er is saving a whopping $354 a year — or just $29.50 a month.

Most folks under 25 aren’t thinking about retirement — which is too bad, because if you put your savings to work 40 years before you retire, you’ll get a much bigger bang for your buck. Assuming a 7 percent rate of return, your $345 a year would turn into $73,323 in 40 years.