A few years ago, I was bored one Saturday afternoon. My idea of a good time was to go through my wife’s pay stub, and type up a detailed document to help her understand everything on it. My goal was to clearly explain to her the implications of the various taxes and deductions. I wanted to enable her to better understand her income and, accordingly, to make better financial decisions.
I know, right? Trust me though, I’m not always so boringly intense to be around. Anyways, I recently found that document, and thought it would be helpful to share the same information here.
You know when you look at your pay stub, and there are eight to ten sections for taxes, deductions, and other information, each with their own line items? It can be daunting to reconcile all those bits and pieces, and to understand how they fit together.
Think of it like this, though: You probably wouldn’t go to your job every day if you weren’t getting a paycheck. So why not take a few minutes to understand how it works?
At the end of the day, what you care about the most is how much is actually being deposited to your account. But before your money makes it that far, it passes through quite a few filters. There are benefits to understanding what these filters are, and how they can be optimized.
These benefits include:
- Full understanding of your income and tax situation
- Stronger knowledge of your employer-paid benefits
- Better understanding of what you really need when negotiating a salary
- Firmer grasp on how much you could potentially be saving (both towards retirement and otherwise)
All of this information can help you make the most of your current job situation/benefits package. It can also help you evaluate a new job offer (it turns out there’s much more to look at when weighing a job offer aside from salary). But you can’t ask for something if you don’t understand what it is to begin with.
So let’s get to understanding that pay stub.
Gross vs. net pay
Gross pay is your annual salary before any taxes and deductions are applied. To calculate what your gross is per paycheck, divide your annual salary by the number of paychecks you receive in a year. Most people are paid bi-weekly, so they receive 26 paychecks per year.
If your base salary is $50,000, your gross pay per paycheck will be $1,923 ($50,000 / 26).
Your net pay is what’s left after taxes and deductions are applied to your gross pay. Net pay is often referred to as take-home pay, and it’s the number you care the most about.
Most people are aware of the distinction between gross pay and net pay. The power lies in understanding the gap between the two, and how it can potentially be optimized.
That will be the focus for the remainder of this article.
Income tax allowances
When you start a new job, there’s a lot of paperwork and forms to be filled out. One of those forms is the W-4. The W-4 tells your employer how much federal income tax to automatically withhold from your paycheck. This is determined based on the number of allowances you claim on the W-4.
In general, the more allowances you claim, the less income tax will be withheld from your paycheck. Depending on your personal situation, it’s important to understand what this means so you can ensure your W-4 is filled out correctly.
You may be single, married filing jointly, married filing separately, or you may have children (dependents). The simplified rule of thumb is that an allowance should be claimed for each person you are responsible for when you file. If you are unsure how many allowances you have claimed, it is printed in the top section of your pay stub.
The number of allowances you claim does have nuances. Do you want a large refund when you file your taxes? Do you prefer to pay less taxes now and owe at tax time? Or do you wish to make it as close to a wash as possible?
A hefty refund may be to your disadvantage
It may seem exciting to get a nice refund every year, but here are some things to consider:
Getting a refund is always a nice feeling, but you are actually giving the government an interest-free loan. You do this by having too much tax withheld from your paycheck. The dollars you overpay sit in the government coffers throughout the year, and are then refunded back to you at tax time. Think of what you could do if you had that money available throughout the year. You could invest it in the stock market, earning market gains and dividends. You could pay down interest-bearing debt, such as credit card debt. But the government doesn’t pay you interest when it gives your money back to you in the form of a refund.
If you get a large tax refund, it can be easier to justify squandering it. One year, I took my hefty refund and purchased a flat-screen TV and a PlayStation 3. If I had that money coming into my paycheck steadily throughout the year, rather than in a lump-sum, I probably wouldn’t have spent it in this same way.
This all depends on the person. Maybe you will be more likely to save a portion of a large refund than you would be to save in smaller increments throughout the year. Maybe you have legitimate expenses that you plan to cover with your refund.
Everyone’s situation is different, but the point is to think about what’s best for you and make the most informed decision possible.
Everyone in America knows that their income is taxed, because we tend to talk about taxes a lot. But not everyone understands the buckets and calculations behind those taxes.
When it is withheld, your income goes into four tax buckets. These buckets include:
- Federal income tax: progressive rates based on income amounts (see table below)
- State income tax (where applicable, not all states have income tax)
- Federal Insurance Contribution Act (FICA) taxes. This comprises two sub-buckets:
- Old Age, Survivors, and Disability Insurance (OASDI), commonly known as the Social Security tax
- Hospital Insurance (HI), commonly known as the Medicare tax
|Marginal Tax Rate||Income Threshold (Individual)||Income Threshold (Married filing jointly)|
|10%||Up to $9,525||Up to $19,050|
|12%||$9,526 to $38,70||$19,051 to $77,400|
|22%||$38,701 to $82,500||$77,401 to $165,000|
|24%||$82,501 to $157,500||$165,001 to $315,000|
|32%||$157,501 to $200,000||$315,001 to $400,000|
|35%||$200,001 to $500,000||$400,001 to $600,000|
|37%||over $500,000||over $600,000|
It’s important to understand the withholding amounts for each bucket1 (and how they are calculated). It makes it possible to determine how much of your gross pay will go towards taxes. It also makes it possible to quantify various tax advantages available to you, which will likely provide a stronger incentive to contribute money to, say, a 401k or HSA account.These tax categories, and the dollar amount withheld from your income for each, are printed on your pay stub in the tax deductions section.
Marginal vs. effective tax rate
There is a big difference between marginal tax rate and effective tax rate, but this is often overlooked.
A single person earning $50,000 would have a marginal tax rate of 22%, but an effective tax rate of 13.9%. What does this really mean?
The marginal tax rate simply looks at the highest tax bracket applicable based on a person’s earnings (in this example, that is 22% as indicated in the table above). But the effective tax rate is what you should pay the most attention to. It tells you the percentage of your income that ultimately goes to federal income taxes.
How to calculate effective tax rate
The process of calculating effective tax rate is pretty straightforward. You simply calculate total tax owed (based on the marginal tax brackets in the table above), and determine what that number is as a percentage of your salary.
For example, consider a person with an annual salary of $50,000. Their federal income tax breakdown looks like this:
|Marginal Tax Bracket||Calculation of Tax Owed||Tax Owed|
|10%||$9,525 x .10||$952.50|
|12%||$29,175 x .12||$3,501|
|22%||$11,300 x .22||$2,486|
|Total Tax Owed||$6,939.50|
This person owes a total of $6,939.50 in federal income taxes. Dividing that by $50,000 tells us the effective tax rate is 13.9%.
Voluntary deductions include any income that is withheld from your net pay in addition to taxes. Common voluntary deductions include:
- Retirement account contributions (401k, 403b, etc)
- Medical, dental, and vision insurance premiums (less any amount covered by your employer, if any)
- Life insurance (less any amount covered by your employer, if any)
- Disability insurance (less any amount covered by your employer, if any)
- Parking/public transit costs (less any amount covered by your employer, if any)
- Charitable contributions through your employer
More often than not, voluntary deductions are withheld pre-tax. This means those dollars are not subject to federal income taxes. These deductions therefore help to bring down your taxable income, which helps to lower your effective tax rate.
Employer contributions include any contributions that your employer makes in addition to your base salary. Common employer contributions include:
- Matching contributions to your retirement account
- Profit sharing (if any)
- Contributions to FSA/HSA (if any)
- Portion of insurance premiums paid by your employer (if any)
- Portion of parking/transit costs paid by your employer (if any)
You can shelter yourself from taxes by contributing more money to tax-deferred accounts. Tax-deferred accounts include:
- Retirement accounts (401k, 403b, TSP)
- Health Savings Accounts (HSA)
- Traditional/Rollover IRAs
Note the distinction between tax-deferred and tax-advantaged. All tax-deferred accounts are tax-advantaged. But not all tax-advantaged accounts are tax-deferred (I’m looking at you, Roth IRA). For the purposes of this article, we will be focusing on tax-deferred accounts because they are directly available through your employer.
How tax-deferred accounts work
When you contribute to tax-deferred accounts, the contributions aren’t subject to income tax until you withdraw the money years later. This helps reduce your tax burden in the present. And because your contributions are invested, your money grows and compounds tax-free over many years. The money you contribute literally starts earning money for itself.
Most people resist the idea of increasing contributions to tax-deferred accounts, because that money technically isn’t available until retirement age (59.5). Generally, withdrawing from tax-deferred accounts prior to 59.5 will come with a significant penalty (in addition to income taxes). There are legal methods to withdraw from these accounts before 59.5 without paying penalties, but that is beyond the scope of this article.
You will still pay taxes…
You will have to pay taxes when you withdraw from tax-deferred accounts at retirement age. This is why 401k/403b/Traditional IRA accounts are known as tax-deferred accounts. You contribute the money without paying income tax on the front end. Instead, you pay income tax later when you withdraw money from the account.
…but you won’t pay as much
If you aren’t working when you withdraw money from tax-deferred accounts, though, the income tax you pay on those withdrawals will be much lower. That is because you will be in a much lower tax bracket due to not having an income.
The power of saving money in tax-deferred accounts in immense, and it’s something you likely have direct access to through your employer. Understanding the options available will ensure you can make the most of your situation.
Do these things today
Understanding every aspect of your pay stub only arms you with information that can help you. The more you understand how money flows into your life, the more you can act as a gatekeeper and build a better future.
Take some time to review your latest pay stub and piece everything together.
Here are some specific actions you can take today, based on the information shared in this article.
Optimize tax deductions
- Verify the number of allowances you are claiming on your W-4. Ensure this is optimal for your personal situation and financial goals.
- See if you can lower your marginal tax rate by contributing more money to tax-deferred accounts. If your annual salary is $50,000, you could bring your marginal tax rate to 12% by contributing $11,300 of your income to tax-deferred accounts. This would shelter that $11,300 from a 22% tax rate, saving nearly $2,500 in taxes.
See if you can save more
- Compare your monthly net pay to your monthly spending budget. Play around with different scenarios and see if you can make your budget work while putting more money towards retirement or additional savings/brokerage accounts.
- Better manage an increase in income. When your income situation is changing (be it for a raise, promotion, or a new job), you can easily estimate your net pay by subtracting pre-tax voluntary deductions from your gross pay and calculating the effective tax rate on that amount. This will provide a psychological boost that can help you save more.
Learn about your benefits
- Review your 401k/403b plan details. If you aren’t sure how much your company matches contributions to these accounts, become familiar with it. Ensure you are contributing at least enough to your 401k/403b to get the full company match.
- Review your insurance benefits and understand the full premium cost of your insurances, as paid by both your employer and yourself. This will help you evaluate the benefits package if you receive a new job offer. It will also provide a harsh reminder as to how expensive health care is today, which must be acknowledged to sufficiently plan for the future.
- Consider utilizing an HSA if this if offered through your employer’s benefits package. Note that HSA’s are only available through high-deductible insurance plans, so it may not be best for your situation. But if you can manage to open an HSA, the tax benefits are insane.
Matthew L Fichter
What are the steps for changing number of allowances on W-4 form? I claimed “0” because I didn’t really know what I was doing. Now it seems to me claiming “1” is more beneficial.
You would need to talk to your employer to update the info on your W-4. Shoot an email to payroll, or ask your manager to start with.