When you first start a job, it’s exciting. You agree on a salary, and you are thrilled that you will soon be getting paid. If you are receiving a salary of $40,000 a year, and you are paid every two weeks, that means your pay (divided by 26 pay periods) should be $1,538.46 each check. Unfortunately, this isn’t exactly accurate. Your gross pay is $1,538.46 each paycheck, but that is the amount you are paid before everything is taken out of your check. And there are a number of withholdings and deductions that can be taken out of your paycheck before you get what’s left — your net pay.
Federal and State Income Tax Withholdings
One of the first things you might notice is that federal and state income taxes are withheld from your paycheck. Income taxes are withheld for the federal government, and, if applicable, for the state and even local governments.
Your income tax withholding is determined when you fill out a W-4 upon being hired with an employer. You claim the number of exemptions you have, and that amount is used to determine how much should be deducted from each check for the federal and state governments. You can also choose to include an extra withdrawal amount for taxes on your W-4. Sometimes, there is a separate worksheet that you can use for state income tax withholding.
If too much money is withheld from your paycheck, you receive a refund after you file your tax return. If you you haven’t paid enough, you will need to make up the shortfall — and possibly pay penalties. Many people like to withhold extra in order to boost their tax refund amounts. However, others argue that this is a bad idea, and you should withhold as a little as possible so that you aren’t giving the government an interest-free loan.
You can adjust your tax withholding if you feel you have been keeping out too much or too little.
Social Security Tax and Medicare Tax (FICA) Withholdings
Income taxes aren’t the only monies withheld from your paycheck and passed on to the government. The Federal Insurance Contributions Act (FICA) requires that money be held out of your paycheck for Social Security and Medicare.
The amounts held are 12.4% for Social Security and 2.9% for Medicare. If you work for a more traditional employer, though, you will find that your paycheck isn’t diminished by that much. Your employer pays half your FICA, so your responsibility, amounts to 6.2% and 1.45%, respectively (for 2011 your Social Security tax is reduced to 4.2%).
This money goes toward funding the Social Security and Medicare systems to help you supplement your income and insurance needs when you reach retirement age.
Beside tax withholdings, there are other items that could be deducted from your gross pay. These include items that are more beneficial to you directly. These deductions include:
- Employer-sponsored retirement plan. Contributions to your 401(k) or 403(b) plan comes directly out of your paycheck as you instructed.
- Insurance premiums. Health, dental, vision, disability, and life insurance premiums could be deducted your paycheck depending on the options available and your benefit election.
- Flexible Savings Account contributions.
- Direct deposit. Some employers let you automatically deposit some or all of your money into a bank account.
Some of these deductions can be helpful, because they can help you reduce your taxable income.
Net Take Home Pay
What’s left over when all of the taxes and deductions have been removed from your paycheck is your net take home pay. It might be that your net take home pay is several hundred dollars less than your gross pay. As a result, your first paycheck can be a little disappointing. However, as you become used to the situation, you will be able to more effectively budget. Indeed, your regular budget should be based on your net take home pay, and not on your gross pay. If you plan based on your gross pay, you will be unable live within your mean.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.