Gross vs. Net Income: Understanding Your Paycheck Deductions

We all know that our take-home pay is less than the rate or salary at which we are officially paid. This is due to a series of deductions. Your base pay before deductions is known as gross income. After all taxes and deductions, the final take-home amount is known as net income. It is important to understand all the deductions that are removed from your gross pay to ensure you are receiving the appropriate amount of pay, paying all mandatory deductions, and taking advantage of employer-provided benefits. Deductions are either mandatory or voluntary.

Mandatory Deductions

Federal Income Tax

One of the most familiar deductions for most is federal income tax. In the United States, federal tax rates are based on tax brackets. The brackets increase as your income increases. Depending on how much you earn, your federal tax rate could vary from 10% up to 37%. However, the important thing to note is that you only pay the higher tax rate on the salary that exceeds the previous tax bracket. For example, if 90% of your income falls within the 12% tax bracket, but the remaining $5,000 of your income falls within the 22% tax bracket, your entire income is not taxed at 22%. Rather, only $5,000 is taxed at the higher rate, and the remaining income is taxed in the 12% tax bracket. This is an important distinction because I often hear individuals discussing tax brackets and wanting to keep their income from tripping the next bracket. In general, this is not something the average earner needs to be concerned about because the higher bracket only applies to the portion of the income that exceeds the lower tax bracket ceiling.

State/Local Income Tax

When it comes to state income tax, the ranges can vary substantially. Some states utilize a flat tax. Under a flat tax system, the rate is the same regardless of how much income is earned. Other states employ tax brackets similar to the federal tax system. However, if you are fortunate enough to live in one of the nine states (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming) that do not charge state income tax, then you will enjoy more disposable income. However, states sometimes compensate for the lack of state income by increasing other taxes within the state, such as property tax and sales tax.

Federal Insurance Contributions Act (FICA)

If you see FICA on your paycheck deductions, this is a combination of Social Security and Medicare. The total FICA rate is 15.3%, which consists of 12.4% Social Security tax and 2.9% Medicare tax. This amount is split between the employer and employee, meaning the employee only pays 7.65%.

Social Security Tax: Old-Age, Survivors, and Disability Insurance (OASDI)

Your Social Security tax may appear on your paycheck deductions as “OASDI.” Originally, “Social Security” was established to provide a source of income for elderly or disabled individuals unable to work. It is funded during the individual’s working years. The OASDI tax rate is 12.4%; however, this amount is split between the employer and the employee. Unless you are self-employed, then you are only responsible for 6.2%. Self-employed individuals must pay the full 12.4%.

Medicare Tax

Medicare tax is similar to OASDI in that there is an employer portion and an employee portion. The total Medicare tax is 2.9%. This amount is split between the employer and employee with each paying 1.45%. Again, self-employed individuals will be responsible for paying both amounts. Medicare is also intended to assist the aging and disabled; however, Medicare is not a benefit paid to the individual. Instead, it is federal health insurance for those older than 65 or others who qualify, such as disabled individuals.

Voluntary Deductions

Retirement Plans

Planning for retirement is essential, and retirement plans offer the best mechanisms for ensuring you can maintain the desired quality of life after retirement. Employer-sponsored retirement plans typically fall under a 401(k) or Thrift Savings Plan (TSP), which is the federal government’s equivalent of the 401(k). If your employer offers a retirement plan, determine if they contribute to it or if they offer matching. For example, if your employer offers 3% matching, then the first 3% you contribute is doubled by your employer contributing the same amount. If your employer matches contributions, make every effort to contribute to your account because you immediately receive a 100% return on the matched amount by doubling your investment.

If your employer does not offer a 401(k) or TSP, then you can open an individual retirement account (IRA). While there will be no employer contributions, you can still take advantage of the tax benefits of the IRA. When opening an IRA, you can choose between a Roth IRA or a Traditional IRA. The only difference is when the money is taxed. Under a Roth IRA, your money is taxed before you contribute, but any growth and earnings are tax free. In contrast, contributions to a Traditional IRA are tax free, but the growth and earnings when you withdraw the funds are taxed.

Medical and Dental Insurance

In addition to the mandatory deductions, you may also see a series of voluntary deductions, such as health insurance or dental insurance. You are not required to obtain these from your employer; however, if it is an option, it is highly recommended, as you will generally pay a substantially lower insurance premium through your employer due to the employer covering a portion of the premium. Insurance premiums vary greatly depending on the level of coverage you select, but even if you are healthy, it is worth investing in health insurance because one accident or emergency can result in a substantial hospital bill. Insurance providers negotiate with health providers to establish rates for each service, which are typically much lower than the rates charged when paying out of pocket (without health insurance).

Life Insurance

Life insurance is another optional deduction. The value of life insurance is largely dependent on your life situation. If you are single with no family, then you may only wish to take out a small premium to cover funeral arrangements. Alternatively, if you have saved a substantial amount that is sufficient to cover these services, then you may not require life insurance. However, if you are married or have children or aging parents, consider their financial situation should you pass away. Insurance exists to help when the unexpected happens, so do not be caught off guard. Look at your situation and make the choice that fits your lifestyle.

Conclusion

Net pay is lower than gross pay. This is due to the mandatory and voluntary deductions. You are required to pay taxes, including federal, state/local (if applicable), Social Security, and Medicare. However, your employer may offer additional benefits that are voluntary, such as a 401(k) retirement plan, medical/dental insurance, and life insurance. One key advantage of employer-sponsored retirement plans is the potential for your employer to match a portion of your contributions, increasing the amount invested. Medical, dental, and life insurance are typically less expensive through your employer due to a portion of the premium being paid by the employer. It is essential to understand what deductions are removed from your gross pay and what benefits are available through your employer.