If you’re like most people, at some point you’ve looked at your pay stub and your check, and had a hard time reconciling what happens to your money before any actually gets to you. Between the impact of federal, state and local income taxes, payroll tax, contributions to your retirement plan and deductions for insurance and other benefits, your take-home pay could be substantially smaller than what you actually earned.
Ready to finally understand your paycheck? Keep reading for a breakdown of what you need to know.
Adding Up Your Gross Pay
Depending on the work you do and how you’re compensated, the money you earn may be described as salary, wages, commissions, bonuses, tips, income or something else. This is also where you would see vacation, sick, holiday, or other forms of compensation listed.
This is your gross pay before any deductions are made from your paycheck. Start here to make sure your employer is paying you correctly based on how you are paid — i.e., hours worked times hourly rate, the portion of your salary you are owed for the pay period, any bonuses, commissions or tips owed, and so on. Once you’ve made sure this gross pay amount is correct, then you can make sense of the deductions.
Two Main Types of Payroll Deductions
There are a number of things that could be deducted from your gross pay, but they mainly fall into two groups: before-tax and after-tax.
What difference does it make? In short, before-tax deductions will reduce your taxable income, meaning you pay less in taxes. Here are some of the most common before-tax deductions you may see on your pay stub:
- Retirement plan contributions.
- Health insurance premiums.
- Dental plan premiums.
- Vision plan premiums.
- Life insurance premiums.
- Health savings account contributions.
- Flexible health or child care spending account contributions.
Since the federal government allows people to deduct these items from taxable income, your employer can make things a little easier and subtract these items from your pay, and then use the remainder — your taxable income — to determine how much tax to withhold.
There are other things that don’t qualify for pre-tax deductions, called appropriately after-tax deductions. These can include contributions to a Roth 401(k), child support payments, retirement plan loan payments or others. These things still come out of your pay, but they won’t lower your taxable income.
Different Kinds of Taxes and How They Affect Your Paycheck
Taxes include federal, state and local income taxes, and also the Medicare and Social Security tax which may be called FICA or payroll tax on your pay stub.
First, federal income taxes. How much is deducted from your pay is determined based on several things:
- Your year-to-date income and federal income taxes deducted.
- Your income in the pay period.
- W-Allowances and additional withholdings you selected on the IRS Form W-4.
How much you earn is the biggest driver behind how much federal tax your employer withholds each pay period. But an improperly filled-out W-4 can also have major consequences, since this form tells your employer how much to withhold, based on the number of allowances (your spouse, dependents and several other child care related items) you claim.
The short version is this: Claim too many allowances and your paycheck might be bigger, but you’ll end up writing a check to the IRS on April 15. Claim too few allowances, and more of your check will be withheld for federal taxes than you owe, and then you’ll get that money back when you file your taxes. Filling out the Form W-4 accurately will help ensure your employer withholds the appropriate amount from your paycheck, based on your income and dependents.
It’s also important to update your W-4 if you have a major life change, such as the birth of a child, get married or divorced or experience some other change to your tax status.
When it comes to Social Security and Medicare tax, it’s pretty simple. Here are the 2017 rates:
- Social Security is 6.2% of the first $127,200 in earned income.
- Medicare is 1.45% of all income, plus an additional 0.9% for earnings above $200,000 for single filers.
- The extra 0.9% is applied to income above $125,000 for married separate filers, and $250,000 for joint filers.
State and local taxes can vary greatly from one place to the next, so it’s best to check with your state or city’s tax or revenue website for specifics where you live.
Getting to the Bottom Line, and What You Can Do to Stretch That Number
Now that you have a better idea what all the numbers mean, you should be able to better understand how your employer got to the “net pay” number that shows up on your paycheck. You should also think about doing a few things to make your money go further, too.
The first place to start is with your Form W-4. It’s important to make sure you are claiming the proper number of allowances to get the most bang for your buck. It may be nice putting fewer allowances, taking a smaller check and getting a big tax return, but it’s actually a pretty inefficient way to manage your money. A smarter thing to do would be to claim the right number of allowances, and contribute more money to savings or toward paying off credit card or other debt every pay period.
Another smart move would be to increase contributions to pre-tax benefits, especially things like a 401(k) or health spending account that you will almost certainly need. If you are in the 25% tax bracket for 2018 — the median American household will be — you’ll cut your income taxes by $250 for every $1,000 you contribute to your 401(k), flexible spending account or other pre-tax benefit you may not currently take advantage of. That’s basically a free $25 from the government for every $100 of your own money you contribute.
This piece was originally published on The Motley Fool. It is reprinted with permission.