Do you know how much you pay in taxes? When is the last time you looked at your pay stub? Do you understand it?
If you have not looked at your pay stub recently, tax season is a good time to review it. Most people only look at their net pay, but understanding where your money is going is important.
There are many types of taxes, and understanding how each one affects your bottom line can help you plan throughout the year to reduce your tax bill either today or in the future.
Most people focus only on reducing taxes today, but sometimes that is unwise. Sometimes, it is better to pay taxes today if you think you may pay more taxes in the future.
Let’s review a pay stub and go line-by-line to identify what may be on your pay stub and how it affects you. If you are self-employed, this article is not for you. You have many other planning opportunities and complexity.
What is in your Paystub?
If you are like most people, you will see many different line items. Near the top, you should see Pay Period. Pay period is the date for which you were paid and dictates how often you will be paid.
For example, there are four main pay frequency options, which is how often payments are made:
- Weekly: 52
- Biweekly: 26
- Semi-Monthly: 24
- Monthly: 12
Although many of these seem obvious, it’s important to understand that if you are paid biweekly, you receive 26 paychecks per year. You are paid every other week, which is why it works out to 26 paychecks. This is important for planning purposes as you budget.
Many larger employers tend to pay biweekly or semi-monthly while smaller employers with fewer resources may pay monthly.
You should also see Gross Pay near the top. Gross pay is your total income for the time period specified. Gross pay is before any deductions, taxes, or other adjustments are made. While gross pay is the total amount of money you earn, it is not the amount that will be taxable to you because of possible deductions.
Below gross pay, you may either see Tax Withholdings or Deductions. Under tax withholdings, you’ll see many different line items.
You’ll see Federal Income Tax, Social Security, and Medicare. If you are in a state with an income tax, you’ll also see a line item for State Income Tax. If you are curious which states do not have a state income tax, they include Washington, Nevada, Wyoming, South Dakota, Alaska, Texas, and Florida. Tennessee and New Hampshire have no wage tax, but they do tax interest and dividends.
In 2020, the five states with the highest income tax include California, Hawaii, New Jersey, Oregon, and Minnesota. All of them are above 9%.
The Federal Income Tax is the amount of money withheld from your paycheck. It is not an accurate accounting of what you will owe by April 15 of the following year. The amount withheld is determined by what you put on your W-4. The W-4 tells your employer how much to withhold from each paycheck.
The W-4 used to ask for how many allowances you wanted to claim, but they simplified it. Now, it only asks about multiple jobs, your spouse’s work, dependents, and other adjustments.
If you ever want to know whether enough is being withheld, the IRS has a tool. The estimator will ask you a series of questions to determine if you are on track to withhold enough money or if you may owe on April 15. It will also tell you how to adjust your withholding for Form W-4. If you find you are owing money or receiving a large refund by April 15, this tool will help you make adjustments to better plan for future years.
Please keep in mind your total federal taxes are based on your taxable income. If you earn income from another job, dividends, interest, or other incomes sources without withholding, you may need to withhold more money from your paycheck or make estimated tax payments.
Also, a federal tax refund is not a good event.
I know people love getting tax refunds, and it can be a great feeling. I want to acknowledge it usually feels better receiving money than owing money, but a tax refund is nothing more than an interest-free loan to the government.
The money was always yours, but you paid it in sooner than you needed. Think about it this way – do you want to pay your friend $300 today and have them return it six months from now without any interest?
No, you want your money earning interest in your bank account or invested in a brokerage ccount and not on deposit with the federal government earning nothing.
There will be those of you who still want a refund, and that’s okay. If paying in more than required means you get a lump sum after you file and that system works for you, there is nothing wrong with it. It just isn’t the most financially sound strategy. As I’ve written before, sometimes optimizing for your emotional well-being is better than for your financial well-being.
If you live in a state with an income tax, you’ll also see State Income Tax withholding. Your state likely has a similar form to the Form W-4, but for the state level. Like federal taxes, state income taxes often have different brackets.
For example, Oregon’s tax rates for single filers are as follows for 2021. I like to use Oregon as an example because they are our neighbors to the south.
|Oregon Taxable Income||Rate|
|$0 – $3,600||4.75%|
|$3,601 – $9,050||6.75%|
|$9,051 – $125,000||8.75%|
What this means is the first $3,600 of taxable income is taxed at 4.75%. The next dollar you make will be taxed at 6.75% up until $9,050.
For instance, if your taxable income was $20,000 in 2021, $3,600 would be taxed at 4.75%, $5,450 at 6.75%, and $10,950 at 8.75%. Please note I am using taxable income, which is your gross income minus deductions. I am using it for simplicity. If you made $20,000 through your job, your taxable income would likely be lower.
In total, you would pay $1,502. Oregon has a great tax table.
In the case of $20,000 of taxable income, your marginal tax bracket would be 8.75%, but your effective tax rate would only be 7.51%. This is calculated by dividing your taxable income of $20,000 by the total tax of $1,502.
The marginal tax bracket tells you at what percentage your next dollar will be taxed.
The effective tax rate tells you your overall or average percentage paid on your taxable income.
If you ever want to estimate your overall tax liability, this is a good tool.
Next up, you’ll see tax withholding for Social Security. As an employee, you pay 50% of the Social Security tax and your employer pays the other half. The total tax is 12.4%, which means you pay 6.2% and your employer pays another 6.2%.
Unlike other taxes, the tax only applies up to a certain income level. In 2021, you only pay Social Security taxes on annual income up to $142,800. Amounts above that level are not taxed. This means the maximum Social Security tax you can pay in 2021 is $8,853.60.
The more you pay in Social Security taxes, the more you will receive in Social Security benefits in retirement. Your Social Security benefits are based on your highest 35 years of earnings and when you claim benefits. I know most of you are not thinking about it today, but it’s good to know how it benefits you later. For now, your taxes are helping pay the benefits for people collecting Social Security benefits today.
The next tax you’ll see is Medicare. Unlikely Social Security taxes, there is no income limit to which it applies. You’ll pay 1.45% in Medicare taxes on your entire gross income. Your employer foots the bill for the other 1.45% for a total of 2.9%.
If you make above $200,000 in a year as a single filer, you also pay a 0.9% Additional Medicare Tax on amounts above $200,000. This means for every dollar above $200,000, you are paying 2.35% in Medicare taxes. For married filing jointly, it applies to amounts above $250,000.
Your Medicare taxes help fund Medicare, which pays for hospital and medical costs by current Medicare beneficiaries. It also makes you eligible for Medicare when you are age 65 or older. If you paid into the system, you normally don’t need to pay for Medicare Part A.
There is also the Net Investment Income Tax (NIIT), which is a 3.8% Medicare tax that applies to investment income or regular income above a certain amount. I mention it here so that you are aware of it and that it applies to income above $200,000 for single filers and $250,000 for married filing jointly. Given its complexity, however, it’s outside the scope of this discussion.
The Social Security and Medicare taxes are known as FICA (Federal Insurance Contributions Act) taxes. If you combine them, you are paying 7.65% of your gross income in FICA taxes. If you are fortunate enough to make over $200,000, you also have the 0.9% Additional Medicare Tax on top of the 7.65%.
Lastly, you may see other types of taxes. For example, in Washington state, we have a new tax called the Paid Family and Medical Leave. The total tax is a flat rate of 0.4%. Employees contribute 63.33% of it while employers pay 36.67% of it. This means employees pay 0.25332% of their income while employers pay 0.14668%.
It’s tied to the Social Security cap, meaning the tax only applies to income up to $142,800 in 2021.
The tax helps fund leave for employees having a baby or adopting, caring for a family member, or when a serious health condition occurs that prevents an employee from working.
You may also see a tax based on your specific municipality. For example, taxpayers in New York City also pay a city income tax in addition to New York’s income tax.
You can read more about taxes here.
Besides taxes, you may see deductions for other things, such as medical, dental, vision, short-term disability, long-term disability, 401(k) contributions, and HSA contributions.
A few important things to note:
- An HSA is one of the best investment vehicles. You receive a tax deduction for contributions, earnings grow tax-free, and distributions are tax-free when used for qualified medical expenses.
- If you pay disability insurance premiums, the disability insurance benefits would be tax-free to you if you ever went on claim. If your employer pays the premium, your disability insurance benefits would be taxable to you. This is really important because if you pay the premium and receive $5,000 in disability insurance benefits, you receive the full $5,000. If your employer paid your disability insurance premiums and you receive $5,000 in disability insurance benefits, the full $5,000 would be taxable to you. After taxes, you may only receive about $4,475.
- Your 401(k) contributions can help reduce your taxable income. For example, if you make $10,000 in Traditional 401(k) contributions, you will reduce your gross income by $10,000. In essence, you are receiving a deduction for the $10,000 contribution and it is not taxed. The downside is that when you need to take money out of your Traditional 401(k) after age 59 ½, it will be taxable as ordinary income at your tax rate during that time. Roth 401(k) contributions work differently. You make the contribution with after-tax funds, meaning you do not receive a tax deduction; however, future withdrawals are tax-free after age 59 ½.
You may see other miscellaneous deductions in that section. It is accounting for anything paid for by you or your employer.
Once you subtract the taxes and deductions, you arrive at your net pay. This is the amount you actually see show up in your bank account.
Summary – Final Thoughts
The tax code is complex. Most people don’t realize how much they pay in taxes or which taxes apply to certain levels of income.
I know taxes are not fun for most people, but I challenge you to look at your next pay stub. Go through it line by line and reference this post to see if you can understand it better. What surprises you? Are your deductions set up properly? Are you withholding enough for taxes? Should you try the IRS estimator to adjust your withholdings?
Once you understand taxes better, you can better plan for your future by deciding if an HSA makes sense for you, or whether you should contribute to a Traditional 401(k) or a Roth 401(k).
I wish you the best in understanding your pay stub and tax situation better!