Have you ever tried having your paycheck deductions explained by your employer? Most people have their paycheck direct deposited into their bank account and pay little attention to their pay-stub. The primary factor that affects your paycheck is deductions. Your pay-stub has a wealth of information that you need to understand because it directly affects how much money you receive every pay period and whether you will likely pay in additional taxes at the end of the year. To understand the deductions affecting your paycheck it is important to understand some basic terms as well as the different types of deductions available.
3 Basic Sets of Terms to Know
Before looking at specific deductions there are three sets of terms that are critically important to understand. They are gross pay/net pay, pretax/post-tax, and mandatory/voluntary deductions.
Gross Pay v Net Pay
The first set of terms to understand is gross pay versus net pay. Gross pay is the entire amount that you earn before any taxes or deductions are taken out. For example, if you make $10 an hour and worked 40 hours a week your gross pay is $400 ($10/hour * 40 hours).
Net pay is the amount of your actual paycheck. This amount has any deductions and taxes taken out of it. Anyone who has received a paycheck knows they do not take home the entire amount of money they earned based on their hourly wage. This is because taxes and deductions are taking out of the earned amount which gives you your net pay.
Pre-Tax v Post Tax Deductions
The next set of terms to understand is pretax versus post-tax deductions. A pretax deduction is taken out of your gross pay before taxes are taken out. A Health Savings Account (HSA) is a simple example of a pretax deduction. If you choose to voluntarily take $100 of your paycheck and put it in an HSA, the $100 is taken out of your gross pay (before taxes). The benefit of pretax deductions is the total amount of income you pay taxes (taxable income) on is decreased. In this example, you would not pay taxes on the $100 that went into your health savings account.
Post tax deductions are any type of deduction taken out after taxes. A common post-tax deduction is optional life insurance premiums. If you elect additional life insurance that is not employer paid, your payment comes out after taxes have been deducted from your gross pay. As a result, post tax deductions do not reduce your taxable income (i.e. the amount of taxes you owe). The benefit to this is that the life insurance death benefit would come tax free. Another example might be employee stock purchase programs if you are lucky enough to work for a company that offers such a benefit.
Mandatory v Voluntary Deductions
The final set of terms to know to understand your deductions is mandatory versus voluntary deductions. Mandatory deductions are those you do not have any choice about. Federal and state taxes are a simple example of mandatory deductions because your employer must deduct taxes from your paycheck. On the other hand, voluntary deductions are those which you must accept. For example, charitable donations taken directly out of your paycheck cannot automatically be taken out if you have not authorized your employer to do so. Any voluntary deduction requires you, as the employee, to affirm that you want the deduction to take place – essentially it is your choice.
3 Basic Types of Deductions
There are a growing number of deductions you may or may not take out of your paycheck. Every deduction can be broken down into three categories – building block deductions, mandatory deductions, and voluntary deductions.
Building Block Deductions – Everybody Must Pay Them
Building block deductions are any type of deduction every employee must pay. Building block deductions include federal, state, and local taxes.
Federal Income Taxes
The federal government requires employers to deduct a portion of your paycheck for tax purposes. This is typically referred to as your withholding tax. The withholding tax is a partial payment of your annual income taxes and your employer sends it directly to the government. While you must pay federal income taxes it is important to note you can change how much is deducted from your paycheck. Your withholding taxes determined by the number of allowances you selected on your W-4 form. For every allowance you take, less money is withheld from your paycheck. Some people choose to take the maximum number of allowances so their paycheck has very little withholding tax taken out of it, but they are likely to pay in when they file their taxes.
State and Local Income Taxes
Similar to federal income tax withholding, your state and possibly local government may have income taxes as well. Nearly every state has some form of income tax. The states with no income tax include Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Your county or city may have additional taxes as well. Local income taxes are typically required to fund large capital projects such as roads and bridges although most localities opt for an increased sales tax rather than an income tax.
Along with federal income taxes, the federal government also requires every worker to contribute a portion of their paycheck to Social Security. Currently, every employee contributes 6.2% of their gross income directly into the Social Security fund. Employers pay an additional 6.2% per employee as well. The purpose of the Social Security fund is to provide a form of safety net retirement benefit to all American workers. The amount of the benefit is directly tied to how much you earn over your lifetime.
The final building block deduction is Medicare. The federal government requires every employee to contribute to Medicare. Medicare is a government-sponsored insurance plan that provides hospital and surgical benefits to people over the age of 65 or with certain disabilities. You contribute 1.45% of your gross income to Medicare every paycheck. Like Social Security, your employer also pays an additional 1.45%
Mandatory – (Legally Required Withholding)
Many people will only have the building block deductions taken out of their paycheck although there are several additional types of mandatory deductions some people will experience. This category of deductions legally requires your employer to subtract a set amount from your paycheck however it is not for tax purposes and these deductions are situation specific.
The most common type of mandatory deduction are wage garnishments. Wage garnishments can arise from a variety of different sources. The most common types of wage garnishments include IRS and state tax levies, alimony withholding, student loan garnishments, and child support. Some garnishments are initiated by creditors, such as credit card companies, however this is typically a last resort. It is impossible to predict the amount of a wage garnishment for specific individuals because it is dependent upon the type of debt they owe.
Some people become upset the first time they experience a wage garnishment, not because the money is being taken out of their paycheck but because their employer knows about their personal financial status. It is important to understand your employer has no option in this situation. They are served with legal documents requiring them to deduct the garnishment from your paycheck.
If you are experiencing some type of wage garnishment on your paycheck, pay close attention to the amount. Under federal law your employer can withhold no more than the smaller of
- 25% of your disposable wages or
- The total amount your disposable wages exceed 30 times the federal minimum hourly wage
To determine your disposable wages, your employer will subtract the legally required deductions from your gross wages because wage garnishments are post tax deductions.
The final category of paycheck deductions are voluntary deductions. A voluntary deduction is any deduction you actively choose to have. Employers cannot take voluntary deductions out of your paycheck without your authority. In most cases, employers will have you sign a form authorizing the deduction. If you do not want the deduction to take place, simply do not sign the form. Additionally, you can change the amount or frequency of the deduction at your pleasure.
A growing number of employers participate in some type of charitable donation program. In this program, you can elect to take a percentage or specific amount of money out of each of your paychecks. Your employer then donates the money to the partner charity. Like any other type of charitable deduction, you get to claim this deduction on your tax return, not your employer.
There are a growing number of health-related deductions you can take if your employer offers them. This includes insurance, flexible spending accounts, and health savings accounts. If you sign up for medical, dental, or life insurance through your employer, they will deduct the cost of your portion of the deductible directly from your paycheck.
Flexible spending accounts are a type of medical plan where you can set aside pretax dollars (reducing your taxable income) to cover medical expenses during the upcoming year. Flexible spending accounts cover insurance co-payments, deductibles, and prescription drugs.
Health savings accounts offer a similar solution to medical expenses as flexible spending accounts but are only available for high deductible insurance plans. The unique benefit of a health savings account is the amount of money you contribute does not disappear/expire at the end of the year, which is a common complaint with flexible spending accounts. Health Savings Account contributions are pre-tax contributions so they reduce your taxable income.
The final type of voluntary deduction are retirement savings plans. Depending on your employer this could be a traditional 401(k), Roth 401(k), simple IRA, or SEP. Depending on the type of retirement plan these deductions can be either pretax or post-tax. Any retirement plan that begins with the word “Roth” will be a post-tax deduction.
A Quick Review
If you are still confused or have additional questions related to getting your paycheck deductions explained on your pay-stub contact your employer. Now that you understand the difference between gross pay/net pay, pretax/post tax deductions, and mandatory/voluntary deductions you can ask the right questions and clearly have your paycheck deductions explained. The key is to remember there are certain deductions you have no control over because they affect every employee and employer in the country. You also have very little control over mandatory deductions, although the specific reason for the deduction may provide you some flexibility in regards to repayment amounts. Finally, you have complete control over your participation in any activity which leads to a voluntary deduction as well as the amount of the deduction.