Understanding your paycheck

It’s payday — finally! And while you know that not every penny you earn stays in your pocket, sometimes the number of deductions and their amount can be surprising.

It’s often hard to know what’s being withheld from your paycheck, or why. Whether you get a physical paycheck or direct deposit, we’ll help you decipher your paystub and know just where your money is going.

What are the basic sections of a paycheck?  

Let’s start with a few basics. Each cycle, your paycheck will show both your gross and net pay. Your gross pay is the amount of money you made before taxes, withholdings and other deductions. Your net pay is the amount of money you take home after everything is subtracted.

Taxes, withholdings and deductions vary. However, one of the most important differences is how much you can and can’t control. Taxes, for example, are required by federal, state and local governments. But deductions — such as health insurance or retirement contributions — may provide you with more options for how your paycheck gets divided.

How are the deductions calculated?

Now that we’ve got the basics, let’s look at what some of the terms on your paystub mean and how those items are calculated.

For many people, the largest tax on their paycheck is the federal income tax. The IRS determines the federal income tax rate, which varies based on how much money you earn and your filing status. Some states collect income taxes as well. Each state determines its state income tax rate, though there are seven states in the U.S. that don’t have this type of tax. The withholding amount is different for everyone, and in some cases if you work in one state and live in another, you may have to pay taxes to both jurisdictions.

Each worker also contributes to Social Security benefits and Medicare, also known as FICA.  Social Security benefits are financial assistance the federal government provides to citizens who are 62 and older once they retire. Medicare is a federally subsidized program providing health benefits for citizens 65 and older and other citizens with certain exceptions. While the federal government determines Social Security contribution rates, the IRS determines Medicare tax rates. Also, your employer is required to make the same contribution to FICA for all wages earned. While you’re taxed at a specific rate each pay period, your employer is making the same contribution on your behalf.

So how do I keep more of my earnings?

Some employers offer benefits — such as medical, dental, vision or disability — under a “cafeteria plan.” Cafeteria plans allow you to select benefits you really need, with deductions occurring on a pretax and after-tax basis from your paychecks. Pretax deductions mean that no federal Income, Social Security or Medicare taxes are deducted from the money used to pay for your benefits. The result: You’ll pay lower taxes and go home with more net pay. 

The same goes for contributions to your retirement savings account. If your employer offers this option, the amount you contribute to the account will determine how much is taken out of your gross pay.

Your employer may also offer flexible spending account (FSA) or health savings account (HSA) options to help you pay for expenses that health insurance doesn’t cover. A flexible spending account deduction is pre-taxed and used to pay for certain medical, dental or vision care expenses that aren’t covered by your insurance. There's also an option for a second flexible spending account to pay for child and dependent care expenses. A health savings account (HSA) is designed to assist employees with saving for medical expenses while employed and into retirement. In general, an HSA is a tax-exempt custodial account created to pay for qualified medical expenses for the employee, spouse and dependents.

In addition to health-care benefits, many employers provide both short-  and long- term disability coverage. On your paycheck, you may find these terms written out or abbreviated as STD or LTD. The two types of coverage usually work in tandem — short-term disability insurance covers an initial time frame, then long-term disability insurance kicks in if your leave from work is extended.

You may also be able to get life insurance from your employer. With this option, should you pass away, your policy will pay out a certain sum of money to a beneficiary of your choosing. This may appear on your paycheck as group term life (GTL) insurance.

Some employers also offer additional after-tax benefits, such as critical care, additional life and accidental life insurance, which is deducted after net pay is calculated. There are other benefits, such as commuter benefits, that can be deducted on a pretax or an after-tax basis.  Often, these payments are subtracted from your gross pay, meaning you end up paying less tax — a smart move if you regularly use public transport or a parking facility while at work.

Should I have a paycheck strategy?

Determining how to keep more of your earnings depends on your current financial circumstances and your current savings plan. When it comes to deductions, it’s up to you to choose the right insurance or retirement contributions for your situation.

To save more of your net pay, direct deposits could help. As part of your financial strategy, you may be able to direct a percentage of your pay to a savings or investment account. Modern payroll systems usually accommodate payments to multiple banks and give you the option to determine the percentage sent to each account.

For full details about the taxes deducted from your paycheck, you can find more information on the IRS website.