Anatomy of a paycheck
More than just taxes come out of your paycheck. Understand how it works, and what each line item could mean to you.
What I want to do in this video is go through the anatomy of a paycheck or a pay stub. And the reason why I want to do it, is because I remember the first time that I had a paycheck, a proper pay stub as well, that I was shocked by how little I was getting relative to how much I thought I was getting.
So for example, in this paycheck right over here, it’s obviously a fictional one, my gross earnings are $3,000. This is what is typically quoted to you when you say how much you make in terms of either on a weekly basis, monthly basis or annual basis. We’re assuming that this is a bimonthly paycheck.
So I get two paychecks a month like this. So I’m making roughly $6,000 a month, gross earnings.
But you see that the check here is not for $3,000. It is for $1,585. It’s a little more than half of my gross earnings. So where did all of that money go? And the answer is, it’s going to the deductions over here.
These deductions could be categorized really into two buckets. The first several, by law are things that you have to pay. So many employers will typically take it out for you.
So these are statutory deductions.
Statutory. By law, you have to pay these things.
The first line right over here and depending on who you are, it could be different, but it’s typically the largest statutory, typically the largest deduction taken out of your paycheck, which is federal income tax.
This is your contribution to the federal government, to allow the federal government to run.
And as you can imagine, as if your taxable earnings go up, then this number typically is larger and not only is it larger in absolute terms, but it typically as you go into higher and higher tax brackets, becomes a larger percentage of your total taxable earnings.
Now the next line here, this is state income tax.
Most states have a state income tax. A few of them don’t, but if you’re in a state with State income tax, this is your contribution to the operations of the state.
And then these last two lines. This is social security and Medicare and Medicaid, in other videos will go into more depth of what these programs are. But these once again are statutory deductions to help fund these federal programs.
Social security is going to be 6.2% of your gross earnings and Medicare/Medicaid is going to be 1.45%.
Now everything below that, at least in this example right over here, could be considered voluntary deductions.
Now you might be wondering, why would anyone voluntarily take money out of their paycheck, why wouldn’t they want to keep it?
And the answer is, most of these voluntary deductions allow you to save or pay for things on a pretax basis, which means you get to pay for these things, or save for these things, without having to pay your incremental tax rate.
So let’s say, this person, I guess it’s me in this example. Let’s say I’m in the 25% tax bracket, which means that incremental dollar that I earn, I have to pay $0.25 – and let’s say that’s just for federal income taxes, I have to pay $0.25 on that dollar.
If I’m able to buy things on a pretax basis, I don’t have to pay my taxes before paying for those particular expenses. I can just pay for them before paying taxes on those amounts. So it’s essentially a pretty nice savings and in other videos we’ll go more into the details of it.
But just to understand what these lines typically are – many employers will provide insurance for you but they’ll require you to pay some of it. Sometimes they’ll ask you to pay 10% of the insurance cost for yourself and maybe 20% or 50% of insurance costs for your family.
So this line right over here is that. It’s your contribution to pay your insurance premium.
You premium is just what someone pays to the insurance company every month, in order for you to have insurance.
So your employer might be paying the bulk of it, but you also have some contribution, right over here.
The next line is a retirement savings plan and this could be a 401K. This is something that you would contribute to so that you can save on a pretax basis. That’s your incentive for doing it.
Another incentive, some people feel that hey, if the money is taken out before I have a chance to spend it, then that’s going to force me to save. So it’s typically pretax and it’s a nice way of enforcing discipline on savings.
This next line is Charity. A lot of employers often allow you to just – hey, if you want to contribute to a worthy cause – to take it out ahead of time from your income.
Now charity is typically tax deductible and so you might say, “Well why don’t you just pay and deduct it later?” But this might simplify the process and once again, it might give you some discipline.
So okay, I’m going to give a certain percentage of my income to charity every two weeks or every month.
And then this last line here, at least for this particular pay stub, his Health/Child Care Plan
Many times you have available to you a flexible spending account where you could put money into a bucket that could be used on a pretax basis, either for health care costs that aren’t covered by insurance or for child care costs. And so that’s what I’m doing in this pay stub, right over here.
And so after paying everything, I’m walking away with a little bit more than half of my gross earnings.