Module 4.3: Understanding payroll deductions and income taxes
Learn how Social Security deductions, Medicare deductions, workers’ compensation insurance, and income tax work, including tax brackets and standard deductions. Figure out how to calculate your net hourly pay. Also: Learn how to increase your number of “allowances” to prevent giving Uncle Sam an interest-free loan out of your paychecks.
Competency: Jump$tart Coalition (2015), Employment and Income: “Standard 3. Analyze factors that affect net income” (p. 23).
Payroll deductions. When working, 15.3% of your pay is deducted for FICA payroll taxes, which includes 12.4% to Social Security and 2.9% to Medicare. These payments are mandatory. However, on your paycheck, only half of these deductions are shown (7.65% of gross pay). The other half is paid silently and invisibly by your employer. Workers’ compensation and unemployment insurances provide medical benefits and income, and are also paid silently and invisibly by your employer.
Net hourly pay. Your “net” pay is what is left over after taxes and work-related expenses. Consider your gross hourly pay and how much you typically pay in income taxes. This requires you to look at last year’s tax return(s). You should check how much you paid in federal income tax and then divide that into your gross income. For example, if you paid $2,800 in income tax and made $40,000 ($20.00 per hour), you would divide to get .07 (meaning, 7% of your gross income went to income tax). If applicable, add state income tax (let’s say it is $400, or .01 / 1%). Then, we are going to add .08 for FICA payroll taxes. We are up to .16 now. What other expenses do you incur with your job, such as laundry, clothes, supplies, and travel (e.g., car, gas, maintenance, etc.)? Divide those into your gross income as well and add the result to our .16 figure. Let’s say you had $1,600 in expenses last year. That’s .04, which when added to .16, brings us up to .20, or 20% of your gross income. Now, let’s find the reciprocal and multiply it by your gross hourly pay. The reciprocal is 1 minus .20 = .80, which can be referred to as your “net hourly pay factor” (or something like that). Multiplying $20.00 per hour by .80, we see your net hourly pay was $16.00 per hour. This is a valuable figure when making purchase or time management decisions. For example, if you’re considering buying a $60.00 video game ($64.80 with 8% sales tax), you can picture it taking about 4 hours of work to pay for it. Is that game worth 4 hours of work to you? Similarly, let’s say you have a bank overdraft fee of $37.00 due to a mistake with your debit card. If you complain and get a courtesy refund of that fee, that’s the equivalent of having saved 2 hours, 19 minutes of labor (37 / 16). Using this mathematical perspective will help you make better financial decisions throughout your life.
Income taxes. These taxes range from 10% in the lowest bracket to 39.6% in the highest bracket. Many people pay no income taxes or get money back, due to the Earned Income Tax Credit and other credits, particularly if they are lower-middle class with children. Tax brackets work cumulatively; only the portion of your income that is above the next threshold is taxed in the higher bracket. However, it is understandable when people want to avoid increasing their income. Increasing your income can increase your income taxes, decrease your federal health insurance tax credit under the Affordable Care Act, and decrease your Earned Income Credit, in addition to increasing your FICA liability. Effectively, there are situations where you may lose over 50% of your additional income, if your state collects income tax as well.
IRS form W-4 and allowances. If you receive a large refund on your federal income taxes each year, you may be allowing the IRS to withhold too much of your paycheck. The solution is to fill out and file a new IRS W-4 form with your employer, with a higher “total number of allowances” on line 5. This will result in your employer withholding less money, and thus sending less money in advance payments to the IRS. The IRS expects you to pay your income taxes in advance, and there are penalties associated with repeatedly owing money on your tax return each year. However, if the IRS repeatedly owes you many thousands of dollars, you are basically giving Uncle Sam an interest-free loan every year. There is a worksheet to calculate your recommended number of allowances on the IRS W-4 form, and Intuit TurboTax has also provided a calculator that may be easier to use. Typically, if you have not filed a W-4 with your employer, you have zero allowances, meaning the maximum amount is being withheld each pay period—typically far more than what you actually owe.
Sources for IRS W-4 information:
Information in this course relating to taxes, accounting, and other financial or legal situations is provided for informational purposes only, and does not constitute tax, legal, or accounting advice. Please consult with professionals if you require advice. (“Advice,” in this context, is a term with legal implications—the giver of advice, must have credentials, is liable, and can be punished for giving bad advice—and, of course, is being paid for the service of providing the advice, due to the expertise and risk that is required to give advice.)