Your income is your most powerful wealth building tool. Like the saying goes, “It’s not how much you make, but how much you keep that makes you wealthy”. If you’re a W-2 employee (majority of workers are), you will be most likely paid on a schedule (weekly, bi-weekly, semi-monthly or monthly). When you get paid, typically, you get issued a paycheck stub, even if, like most employees, you elect to have your paycheck directly deposited into a bank account. The stub explains all the financial details of your income for that pay period. Learning how to read your paycheck stubs can help you to better track your income. Once you understand the layout and terminology of the paycheck stub, you can accurately track how much money you earned, how much money you took home, and how much of your earnings were given to any withholdings. Keeping a careful record of your earnings will help improve your overall personal finances.
Often, people complain, where did all my money go? Well, your paycheck stub will help clarify this. And if you understand it well, you will also notice if there are any errors. Every employer has their own style and format for preparing your paycheck stub but in its simplest form, most paycheck would have the following elements.
1. Identifying Information
This would include your name, employer ID, social security number (mostly the last 4 digits), pay period, the employer’s address and/or your address. Because of the inclusion of your social security number, it is important that you store your pay stubs securely so you don’t become a victim of identity theft
Gross Income: This is the total amount of money you earned for that pay period
Taxable Income: This is the amount of your income that is subject to federal and state (and in some cases, city or county = hello New York City!) taxes. It is roughly equivalent to your gross income minus your pre-tax deductions
Net Income: This is your so-called take home pay. This is the real juice that hits your bank account, and for most people, the only number they care about (Cha Ching!)
Deductions can be pre-tax (meaning before taxes) or post-tax (after taxes). Pre-tax deductions help you save on your taxes. Most deductions are pre-tax and they include
Medical insurance premium
Dental insurance premium
Vision insurance premium
Flexible Spending Accounts: This plan helps you set aside some pre-tax money for medical or daycare expenses
Health Savings Accounts: This is is another way to put pre-tax dollars aside in a special account for medical expenses. To be eligible for a health savings account, you’ll need to select a high-deductible health insurance plan, if your employer offers it
Retirement contributions (401k or 403b, 457):
When you sign up for your employer’s 401k, 403b or 457b plan, you typically elect a percentage of your gross income that you’d like to contribute to your retirement account. This is then automatically deducted with each pay check. If you want to pay less taxes, this is by far the greatest deduction to elect, especially if you max out your retirement plan. Even though your take home pay will be less, but the amount of taxes you pay becomes less too and your contributions to your 401k grows tax deferred until retirement, thus helping you build wealth as it compounds.
An example of post-tax deduction is if you elected to participate in your employer’s Roth 401k or Roth 403b plan. Your contributions will be post-tax (after you paid taxes) so, your take home pay will be much less than with a regular 401k contribution. However your money grows tax deferred AND when you withdraw it at retirement, you never have to pay taxes again.
4. Tax Withholding
This section of your paycheck stub shows how much was deducted from your taxable income to send to
Uncle Sam the federal government (as well as your state government). If you live in one of these nine states with no income tax you will not have to worry about state tax being withheld from your paycheck.
The federal government gets a piece of your
pie money from each and every income. The amount of money withheld for federal taxes depends on the amount of money that you earn and the information that you gave your employer when you filled out a W-4 form, or Employee’s Withholding Allowance Certificate. On a W-4, you can make allowances for yourself, your spouse and your dependents. For every allowance you take, less money gets withheld for federal taxes and more money gets added to your paycheck. Take fewer allowances, and a bigger chunk of your income will be withheld for your federal taxes. Of course, regardless of how little or how big your federal tax withholding is in each paycheck, all these will be reconciled when you file your income taxes the following year (with the consequent effect of receiving a Tax Refund or owing a Tax Payment to the IRS).
As with federal taxes, most states have tax brackets for different income levels and taxes will be withheld accordingly. You can find your state individual income tax rates and brackets here. In my state of Arkansas, the highest state tax bracket is 6.9% and you reach this once your income crosses $35,099 regardless of whether you’re a single filer or married filing jointly. The highest state tax burdens can be found in Hawaii (11%) and California (13.3%). This is why I believe in geographic arbitrage if you want to get ahead financially faster (sorry Californians!). Geographic arbitrage simply means you should engineer your life to work and live in a state with no or low income tax and low cost of living. Have you also noticed the co-incidence that most states with very high state tax burden also have high cost of living (think NY, CT, CA, NJ, VA, MA, DC). To make it even worse, most professionals would also earn less in such states (because of saturation).
FICA (Federal Insurance Contributions Act):
In some paychecks, this is seen as one entity, but it actually comprises two different taxes, Social Security and Medicare taxes
Social Security Taxes: The federal government requires every working American to contribute a portion of their paycheck to Social Security, a system of supplemental retirement programs established in 1935. Every worker contributes 6.2% of their gross income directly into the Social Security fund, and every employer chips in an additional 6.2% for each employee (those who own their own business or are independent contractors pay both portions, or 12.4%). However there is an income cap above which no further social security taxes are withheld. For 2018, that cap is $128,700. This figure is adjusted annually by the IRS to accommodate for inflation. If you’re a high income earner (making above that figure) and you notice your paycheck “magically” became fatter towards the end of the year, this is why…..and, no it’s not magic and the extra money didn’t come from Santa!
Medicare Taxes: The federal government requires every working American to contribute to Medicare, a U.S. government insurance plan that provides hospital, medical and surgical benefits for Americans ages 65 and older, and for people with certain disabilities. Every worker contributes 1.45% of their gross income to Medicare and every employer pays an additional 1.45% on behalf of each employee (those who own their own business or are independent contractors pay both portions, or 2.9%). Unlike social security taxes, there is no income cap on Medicare taxes. So whether you make $30,000 or $300,000, you will pay 1.45% of that whole income on Medicare taxes. Sorry! Some high income professionals who are self employed usually circumvent paying this whole 2.9% Medicare tax on their gross income by forming an S corporation (S corp for short) where they elect some of their income as salary and the majority of their income as dividends. The part of their income elected as dividends is shielded from paying this Medicare tax. But this is a topic for another time.
Track Your Deductions
Each pay stub includes year-to-date fields for each withholding category so you can track how much money you’ve paid for taxes, Social Security and Medicare throughout the year. Many employers include a similar listing for contributions to retirement savings plans and health plans. You’ll generally see these fields marked as the acronym “YTD” on your pay stubs.
It’s important to stay on top of this information. Any errors are your responsibility to find and report to your company’s human resources department. The last thing you want is for an error to be repeated through several pay periods. If you have questions about any of the information listed on your pay stub, be sure to contact a coworker in human resources. Personally I review every single one of my paystub and I’ve once detected an error which I promptly fixed with a visit to the HR department.
A pay stub also lists gross and net income to-date. So you’re able to track just how much money you’re making (your gross pay) and how much money you’re actually taking home after taxes and other deductions (your net pay) throughout the year. You can use this information to build a spending plan, work on reducing your debt or start saving for the future.
Be sure to check that the information on your last pay stub of the year matches the information on your W-2 form, which details your wages and taxes paid for the year. Your W-2 form (different from your W-4 form) is what your employer issues you at the end of the year to use in filing your Income Tax Return.
Wait, What About The Self-Employed?
For those who are independent contractors (self-employed) or own their own business, you might get paid with a 1099-MISC and your income is usually listed on box 7
Usually, those paid with a 1099-MISC will have to pay their own taxes (federal, state and FICA) as the issuer of the 1099 does not typically do any withholdings on your behalf. You can pay your taxes by filing quarterly estimated taxes with the IRS (usually a one-page document) and your state tax revenue office and sending them a check. For the 2018 federal quarterly estimated tax payments, the due dates for each quarter are
April 17, 2018 (for the payment period, January – March, 2018)
June 15, 2018 (for the payment period, April – May, 2018)
September 17, 2018 (for the payment period, June – August, 2018)
January 15, 2019 (for the payment period, September – December, 2018)
In a nutshell, the foregoing is the basic details contained in your paycheck stub. Some employers use some abbreviations and codes to indicate the above categories (like FT for federal taxes, ST for state taxes, SS for social security taxes and MWT for Medicare taxes). If you don’t understand the abbreviations or codes in your pay stub, you can ask your HR department.
So, go and learn and understand your pay stub and take control of your money. And if the above summary is still too fuzzy for you to understand, then click on this 2.5 minutes YouTube video to break it down for you.
Do you understand your paycheck stub or do you always discard it without even looking at it? Does this explanation help you understand it better? Comment below.
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