Your Guide To Navigating Your Paycheck: Understanding Taxes and Deductions

August 23rd, 2024 by Blake Pinyan

It’s essential for employees to understand how their paychecks are calculated. This knowledge helps them anticipate that their initial paychecks won’t match their full quoted annual salary. As we’ll explore, this discrepancy arises from taxes and deductions.

This article will guide you through the intricacies of your paycheck, helping you understand:

• Your offer letter salary
• Income Tax Forms and Allowances
• FICA Taxes
• State Disability and Local Income Taxes (varies by state and locality)
• Employee Benefit Deductions
• Additional Considerations

Offer Letter Salary

When starting a new job, you’ll receive an offer letter outlining your salary. This typically includes a base gross salary, possibly a bonus plan, and sometimes equity (depending on your position and company). It’s important to understand that the offer letter salary is a gross amount — what you’ll earn before taxes and deductions. Your actual take-home pay will be less.

Most employees are paid every two weeks or twice a month (26 or 24 pay periods annually), but some, especially government workers and teachers, are paid monthly. Regardless of pay frequency, the calculation remains the same: Gross salary – taxes – employee benefit deductions = net pay.

For example, someone offered $120,000 annually won’t receive $10,000 monthly or $5,000 bi-weekly. The actual amount depends on factors like tax allowances, state of residence, and chosen benefits.

Income Tax Forms and Allowances

After signing your offer letter, you’ll be asked to complete new hire paperwork, including income tax withholding forms. These forms specify your allowances and determine the amount of federal and state income tax withheld from your paycheck.

W-4 (Employee’s Withholding Certificate)

The federal income tax withholding form is called the W-4. It consists of five steps:

• Entering Personal Information
• Multiple Jobs or Spouse Working
• Claiming Dependent and Other Credits
• Other Adjustments (optional)
• Signature

Step 1: Entering Personal Information

This step requires your name, Social Security number, address, and filing status (single, married filing separately, married filing jointly, qualifying surviving spouse, or head of household). Your filing status significantly impacts the amount of federal tax withheld. Single or married filing separately typically results in the highest withholding, as IRS withholding tables are less favorable for these statuses. Generally, matching your W-4 filing status to your expected tax return status is advisable. However, there are exceptions if you have other income sources that might lead to under- or over-withholding.

Married filing jointly or qualifying surviving spouse results in the lowest withholding due to more favorable tax rates. Head of household falls between these two categories.

Step 2: Multiple Jobs or Spouse Working

Steps 2-4 are optional and depend on your individual circumstances. If you’re single with one job and no dependents, you can likely skip to step 5.

If you have multiple jobs or a spouse who works, you’ll need to complete step 2 to accurately calculate withholding for each job. For example, nurses often work at multiple hospitals and might face higher tax bills if their W-4s aren’t correct. Since withholding is lower for smaller salaries, a nurse with multiple low-paying jobs could owe more taxes at year-end unless the W-4s are completed accurately.

The IRS offers three options for this step:

• Online tax withholding estimator: Claimed to be the most accurate and can be used by the self-employed.
• Multiple Jobs Worksheet: Provides step-by-step calculations based on income levels and filing status.
• Check a box: Simpler option if one job pays significantly more than the other.

Step 3: Claim Dependent and Other Credits

Step 3 allows you to claim dependents and reduce federal income tax withholding through tax credits. The first part calculates a potential child tax credit based on the number of children under 17 ($2,000 per child) and other dependents ($500 each). This credit is fully available to families earning less than $200,000 (single) or $400,000 (married filing jointly).

Claiming dependents on your W-4 increases your allowances (reducing withholding). More allowances mean less withholding, and fewer allowances mean more withholding.

Step 4: Other Adjustments

Step 4 allows for additional adjustments based on your tax situation:

• Other income: Report non-employment income (interest, dividends, rental income, capital gains) to increase withholding.
• Deductions: This option can reduce withholding if you plan to itemize deductions. Use the Deductions Worksheet for calculations. Be cautious as overestimating deductions can lead to underpayment.
• Extra withholding: Manually specify an additional amount to be withheld per paycheck. This is useful if you expect to owe taxes.

Step 5: Signature

Simply sign and date the form. Your employer will also sign and include your start date and the company’s identification number.

Overall

The W-4 form determines the amount of federal income tax withheld from your paycheck. This withholding is deducted with each paycheck and summarized on box 2 of your W-2 form. Your total annual withholding is credited towards your tax liability, determining whether you receive a refund or owe additional taxes. If your withholding exceeds your tax bill, you’ll receive a refund; if it’s less, you’ll owe taxes. In rare cases, withholding and tax liability might match, resulting in neither a refund nor a tax bill.

The U.S. has a progressive tax system, meaning higher income results in higher tax rates. As your income increases, more federal income tax is withheld. Your tax liability is based on income, filing status, and claimed allowances. While the W-4 aims to align withholding with tax obligations, individual circumstances can lead to significant refunds or tax burdens.

State Income Tax Withholding Form (if applicable)

The form for state income tax withholding varies by state. For example, California uses DE 4 (Employee’s Withholding Allowance Certificate). While the specific forms differ, the underlying principles are similar to the federal W-4.

Tax Rates and Withholding

• Some states, like California, have progressive income tax rates.
• Others, like Idaho, have flat rates.
• Some states, like Texas, have no income tax.

Understanding federal W-4 mechanics equips you to handle your state’s equivalent.

Progressive Income Tax Withholding

States with progressive income tax typically ask for:

• Filing status (married filing jointly results in less withholding)
• Number of allowances claimed (dependents or deductions reduce withholding)

Similar to federal W-4, worksheets help calculate withholding amounts. Some states allow opting out of withholding, but it’s generally not advised.

Benefits of Withholding vs. Estimated Tax Payments

Withholding state and federal income taxes from each paycheck is preferred over estimated tax payments. It reduces the risk of penalties and automates the process, eliminating the need for quarterly payments.

Overall

Your state’s withholding form determines the amount withheld for state income taxes. This amount is reflected in box 17 of your W-2 and credited against your state tax liability, resulting in either a state refund or a state tax bill. In rare cases, withholding might equal your tax liability.

Remember, state income tax laws vary by location, so withholding will depend on your state of residence.

FICA Taxes

FICA (Federal Insurance Contributions Act) taxes are deducted from most employees’ paychecks. They consist of Social Security (OASDI) and Medicare taxes, levied at 6.20% and 1.45%, respectively, for a total employee tax of 7.65%.

Social Security Tax

Employees pay 6.2% of their wages toward Social Security, up to a maximum of $168,600 in 2024. This limit, known as the Social Security wage base, means no further Social Security taxes are withheld once earnings exceed this amount. The maximum Social Security tax for 2024 is $10,453. This cap benefits higher earners. The wage base is adjusted annually based upon inflation.

To qualify for Social Security benefits, typically upon retirement, employees must contribute to the program for at least 40 quarters (10 years).

While most employees pay Social Security taxes and are eligible for benefits, some workers, mainly government employees like teachers, are excluded. These individuals often receive pensions instead of Social Security. However, they might qualify for benefits through spousal income or previous employment.

The total Social Security tax withheld is reported in box 4 of your W-2, with the taxable wages listed in box 3. These wages determine your potential Social Security benefit amount.

Note: Social Security taxes do not affect your annual income tax return. They fund your future Social Security benefits.

Medicare Tax

The other component of FICA taxes is Medicare, which is 1.45% of your paycheck. Unlike Social Security, there’s no wage cap for Medicare taxes. This means everyone pays Medicare taxes on their entire income, regardless of how much they earn.

While Social Security benefits increase with higher earnings, Medicare benefits are generally the same for all eligible recipients. Additionally, higher-income individuals often pay higher Medicare Part B and D premiums, offsetting any potential advantage of contributing more.

Similar to Social Security, you need 10 years of Medicare tax contributions to qualify for the federal program. Unlike Social Security, there are no exemptions for government workers. Your total Medicare tax withholding appears in box 6 of your W-2, with the corresponding wages listed in box 5.

Like Social Security, Medicare taxes don’t affect your annual income tax return. They fund your future Medicare benefits.

Self-Employment Tax

While employees and employers each contribute 7.65% to FICA taxes, totaling 15.3% of wages, self-employed individuals bear the entire burden. This is known as the Self-Employment Tax, which equates to 15.3% of a self-employed individual’s net earnings. This can be a significant financial responsibility, especially for those with higher incomes.

Unlike employees who have taxes withheld from each paycheck, self-employed individuals often don’t have regular tax deductions. This can lead to a substantial tax bill when filing their income tax return. To avoid penalties, self-employed individuals should make estimated tax payments throughout the year based on projected income and tax liabilities.

State Disability and Local Income Taxes (State and Locality Dependent)

Your paycheck might include additional deductions for state disability and local income taxes, depending on your location.

State Disability Taxes

California employees pay a 1.1% State Disability Insurance (SDI) tax on their wages. Unlike previous years, there’s now no cap on SDI taxes, meaning higher earners pay more. SDI provides short-term disability and paid family leave benefits to eligible workers.

Besides California, Hawaii, New Jersey, New York, and Rhode Island also have state disability taxes. In California, SDI is reported in box 14 of your W-2 as “Other.”

SDI taxes don’t affect your federal or state income tax returns.

Local Income Taxes

Some cities impose local income taxes, separate from state taxes. These taxes can be flat, progressive, or nonexistent. For example, Kansas City, Missouri has a 1% local income tax, while New York City has a progressive rate ranging from 3.078% to 3.876%. California cities do not have local income taxes.

Avoiding local income taxes is challenging if you live in a city that imposes one. It’s essential to prepare for these taxes and file necessary forms, as some cities require separate tax returns.

Employee Benefit Deductions

Your paycheck may also include deductions for employee benefits. Common benefits leading to paycheck reductions include:

• Medical, Dental, and Vision Insurance
• Retirement plan contributions (401(k), 403(b), etc.)
• Life Insurance premiums
• Disability Insurance (Short-Term and/or Long-Term)
• Health Savings Accounts
• Flexible Spending Accounts
• Employee Stock Purchase Plans
• Charitable or employer-sponsored giving plans

For more details on these benefits, see my other blog posts.

Unlike the fixed nature of taxes, employee benefit deductions vary widely. The amount deducted depends on factors like:

• Available benefits
• Benefit selections
• Contribution levels
• Employer contributions
• Benefit plan costs

For example, Emily’s company offers Health Insurance and a 401(k), while Claire’s offers these plus Life Insurance, Disability Insurance, and a Health Savings Account. Assuming equal base salaries, Claire’s paycheck deductions will likely be higher due to more benefit options. However, if Emily maximizes her 401(k) contributions and Claire contributes minimally, Claire might have a higher net pay. Even with identical benefit packages, differences in plan choices, like opting for a high-deductible health plan, can impact paycheck amounts.

Remember, your employee benefit deductions are unique to your situation. Maximizing contributions or selecting higher-cost plans will result in larger paycheck deductions.

Considerations

Remember these three key points:

• Your offer letter salary is gross income.
• Your W-4 form affects your tax withholdings.
• Your employee benefit choices impact your take-home pay.

Offer Letter Salary

Your offer letter states your gross salary, not your take-home pay. A $100,000 salary doesn’t equate to $100,000 in spending power. You’ll receive income gradually throughout the year, and taxes and benefits will reduce your net pay.

W-4 Matters

Your W-4 determines federal income tax withholdings. Filing status and claimed allowances significantly impact these withholdings. Don’t automatically claim a high number of allowances. Under-withholding can lead to substantial tax bills and penalties. Match your W-4 to your specific tax situation or consult a tax professional. It’s generally safer to have more taxes withheld than to owe money.

Employee Benefits Impact Cash Flow

Your benefit choices affect your take-home pay. Carefully consider your living expenses and budget for benefit costs. High contributions to retirement accounts or premium plans can significantly impact your paycheck. Review your benefit package and calculate the impact on your income. Make intentional choices about your benefits.

Conclusion

Taxes and employee benefit deductions significantly impact your take-home pay. While an enticing offer letter salary might create excitement, remember that it represents your gross earnings, not your net income.

At Anchor Bay, we help clients navigate the complexities of salary, tax withholding, and employee benefits when starting new jobs. Our guidance empowers you to make informed financial decisions aligned with your specific needs.

Your financial well-being is important to us. Let us help you manage your money effectively and reduce tax-related stress.