To understand how to live within your means, it is important to understand your pay, to get to grips with your finances, and to have a sense of your financial freedoms and boundaries.
There are two types of pay outlined on your paycheck. These are net pay and gross pay.
Once you understand these two types, you can effectively calculate your finances.
What Is Gross Pay?
Gross pay is an individual’s initial earnings for a given period before any deductions or expenses (such as tax or health insurance) have been taken.
What Is Net Pay?
Net pay is the money you are left with once all deductions and expenses are taken.
These mandatory and voluntary deductions include taxes, insurance and pensions.
What Is the Difference Between Net and Gross Pay?
Simply put, gross pay is the total amount you earn; net pay is the amount you take home.
Neither pay amount directly includes the value of work perks that you receive instead of additional salary.
What Are Employee Deductions?
As a US employee, you will be subject to the following mandatory taxes:
Federal Income Tax – It is easiest to describe the federal tax system as a progressive one – generally speaking, higher rates are applied to higher income levels. The federal income tax has seven tax brackets ranging from 10% to 39.6%. The amount of taxable income an individual earns decides the income tax bracket for that individual. This is a marginal tax, meaning you pay varying amounts on each dollar as you earn more.
Social Security Tax – Also known as the Old-Age, Survivors, and Disability Insurance (OASDI), the social security tax must be paid by all employees and self-employed earners.
State Income Tax – This is also a progressive tax. All but seven states are subject to it. The level varies from state to state, so become fully familiar with how much you are required to pay by visiting the US government website here. Some cities and counties may also have separate versions of income tax. The state tax can be a graduated or fixed rate on taxable income.
Medicare Tax – Medicare tax provides health insurance to those aged over 65, people with disabilities and people with terminal health conditions. Medicare has two tax brackets: 1.45% for the first $200,000 earned annually and 0.9% for taxable income earned over $200,000.
The last two taxes, when combined, are referred to as FICA (Federal Insurance Contributions Act).
FICA is a specific percentage; half is paid by the employee, half by the employer.
Very little income is exempt from FICA. Only college or university students that work for the institution that they attend may be exempt.
If you are self-employed, you pay under the Self-Employed Contributions Act (SECA), instead of FICA.
Essentially, you pay both halves of the tax, as you are both the employer and the employee. Half of the tax can be deducted as a business expense.
Graduated income tax (also referred to as a progressive tax) simply means the more an individual or a business earns, the higher the tax rate will be that is applied. The more you make, the more you pay.
For calculating which income bracket you are in, you must account for tips as part of your pay.
Not all deductions from your gross pay are mandatory.
You can also have voluntary deductions such as life or medical insurance and retirement plans. If applicable, you might have personally mandatory deductions such as child support.
These may be paid on every payslip or only when you want to, and you may be able to alter the amount of some of these deductions, but this depends on the deduction.
Other voluntary deductions include:
- Union dues
- Pension plans
- 401(k) or other retirement plan
- Health plan
- Health savings account
- Flexible savings account
How to Calculate Net Pay
This is how you calculate your take-home pay.
1. Begin With Your Weekly Gross Pay
When earning a fixed salary, simply divide the annual amount by the number of weeks in the year (52).
If you are paid by the hour, multiply your wage by how many hours you work during the week to work out your weekly earnings.
You will not be able to accurately account for potential tips, but if you have a rough estimate of your average (for example, if you get $100 in tips most nights), remember to include this as well because it is taxable income.
2. Your Number of Personal Exemptions
At the start of every new job you begin, you will be required to fill out a W-4 form. It looks like this.
This tells your employer if you are exempt from any tax, perhaps due to having children or other dependents.
Dig out your W-4 form and check if you are exempt from any taxes.
3. Calculate Your FICA or Seca Taxes for the Year
Ultimately, FICA and SECA cover the same amount – 15.3% of your total pay.
If you are employed by a company (in other words, you are not self-employed), you only pay half of this – your employer pays the other half, making FICA a flat rate of 7.65%.
If you are self-employed, you pay SECA, which is the whole amount of 15.3%.
You can work out the percentage of something by dividing the initial amount by 100 and multiplying by the desired percentage.
So, to calculate FICA/SECA contributions, take your weekly income, divide by 100 and multiply by 7.65 (FICA) or 15.3 (SECA). Then, subtract this from your amount earned.
4. Subtract Standard Deduction
Your standard deduction amount depends on if you are:
- Single or filing separately from your spouse
- Filing jointly with your spouse
- The head of the household
- Over 65 years old
- A dependent yourself
Subtract this amount from the result of step 3 above.
5. Subtract Pre-Tax Deductions
Some voluntary deductions you make will be taken from your gross pay before taxes are applied.
You can expect this category of deductions to include contributions to health insurance, life insurance, a 401 (k) retirement plan or an adaptable spending account for personal medical fees.
Your workplace or those applying the deductions should tell you how much you need to pay. Make sure this is a per-week amount, dividing as necessary. Then subtract this from the result of step 4.
6. Determine Tax Income Bracket
The 2021 tax income brackets are available here.
After step 4, you now have a weekly amount earned after personal exemptions, FICA/SECA and deductions, but before income taxes.
Multiply this amount by 52 to get your annual income. Look at the tax brackets in the link above to see where you fall.
This can be used to calculate how much federal tax you pay.
7. Calculate Federal Tax
Consider the federal tax brackets like a jug filled with your income with markings on the side designating the brackets.
There is not a single tax rate applied to the whole amount – the federal tax rate is marginal, and each bracket only applies to a particular amount of your income.
The top bracket you hit only applies to the amount of income above that bracket’s minimum.
The next bracket down only applies to income above that bracket’s minimum.
The third bracket down only applies to income above that bracket's income. And so on.
Therefore, a separate calculation must be made for each income bracket you hit.
Subtract each bracket’s minimum from its maximum to find the amount that the bracket covers. For each bracket you earn above, this will also give you the amount that the tax rate applies to.
For the highest bracket you hit, because you will only be partially in it, you should subtract the bracket’s minimum from your total annual income (as calculated in step 5).
Using the method of calculating percentages linked above, apply each bracket’s percentage rate to the amount of income you have in that bracket.
Add these all together to work out how much federal tax you must pay.
8. Calculate State and Local Income Taxes
Next, you need to apply any taxes from your state and local county or city.
Go to your state’s tax website to find out about any further taxes you may need to pay at both a state and more local level.
Remember to check whether the taxes are flat rate (like FICA/SECA) or marginal (like federal tax).
9. Other Payroll Deductions
Next, you need to deduct any further voluntary contributions you make. These are any post-tax deductions, which will be different from those made pre-tax in step 5. These can include charitable contributions.
These should be deducted from each pay packet, so take the amount calculated in step 7 (your annual income after state and local taxes) and divide by how many times a year you get paid.
If this is weekly, divide by 52.
Take these voluntary deductions from this amount.
If you pay regularly for a gym membership or a Netflix subscription, deduct those at this point as well, so they are thoroughly accounted for in your budgeting.
Note: make sure to sort these deductions out according to pre-tax and after-tax contributions and apply them at the right time.
The Tax Withholding Calculator
Calculating your net pay as a US worker involves a lot of steps, all of which are places a mistake can potentially be made.
Therefore, the IRS has supplied an estimator to help you calculate how much tax you need to pay overall.
It can also help you estimate how much from each paycheck you should have your work withhold in order to cover all of your taxes and deductions.
It asks you a series of questions, and provided you have an average tax situation (for example, you are not filing for the seven jobs you have in conjunction with your spouse, who also receives payment from outside the US, and you also have three dependents), you should get an amount at the end you can subtract from your pay to account for all your taxes.
Here is an example to illustrate these steps:
James has just accepted a mid-weight copywriter job, where his yearly gross salary will be $28,000.
He is filing as a single person, meaning that he will start with the standard deduction on his W-4 form. He has no children, is below the age of 65 and lives alone.
To find his weekly salary, James will need to divide $28,000 by the number of weeks in the year (52).
$28,000 divided by 52 = $538.46
James has health benefits through his job and pays a health insurance premium of $20 per week. Health benefits are not subject to Medicare, social security or income tax withholding.
His next calculation will therefore be to deduct any pre-tax deductions, such as his $20 health insurance premiums, from his gross wages:
$538.46 – $20 = $518.46
His second calculation will be to calculate FICA tax.
He will multiply his wages after the pre-tax deduction by 7.65% to find the amount that is set aside for FICA.
$518.46 x 0.0765 = $39.66, the FICA tax amount that will be reserved from James’ gross pay.
Next on James’ agenda will be to work out federal income tax – he used the calculator linked above.
Based on James’s status as a single person, under 65 years of age, and with no dependents, his federal income tax should be set at $1,658.
To find the weekly rate for this, James can divide by 52. However, this should all be detailed on an employee paycheck already.
$1,658 divided by 52 = $31.88
James lives in Tampa, Florida, where employees do not have to pay any local or state income tax, so therefore he does not have to allow for this factor. However, it is important to remember that local and state income tax could apply to other places in the US.
Finally, it is time to solve the exact take-home pay. To do this, James will need to subtract all the calculated deductions from the gross pay.
Gross pay = $538.46
Health insurance premiums = $20
FICA tax = $39.66
Federal income tax = $38.66
State income tax = $0
Local income tax = $0
$538.46 – $20 – $39.66 – $38.66 – $0 – $0
= $440.14 per week
When you are offered a job, the salary amount you agree to is your gross pay.
An employer cannot tell you what your net pay will be because every employee's tax withholdings are different, so understanding how to calculate this yourself is a very useful skill.