It’s your first job. You eagerly await your first paycheck, excited to be earning money, only to find that what you know you earned and what you actually receive are quite different. Most individuals at some point or another have wondered what the various deductions and taxes that come out of their paycheck mean.
Before you receive your paycheck amount, the federal government requires various percentages of your gross pay for a few purposes. So what are the various drains on your paycheck, how much and why? To start, even though that decrease in what you thought you would receive can feel quite substantial there are good reasons for it.
Your employer handles the required taxes, withholdings and other contributions on your behalf. Your HR or Payroll department handles these various taxes and withholdings for you to ensure you are meeting your federal and state obligations. So let’s jump into it. Here are the line items commonly on your paystub.
Federal Insurance Contribution Act, or FICA taxes are what most people think of as your Social Security Tax. FICA taxes cover required contributions to the federal Social Security and Medicare systems for the benefit of your future self and other citizens of the U.S. A total of 15.3% of your gross paycheck is taken out to cover these required contributions. As an employee, you only pay half, or 7.65% of this tax, while your company pays the other 7.65% for you.
You may see the Social Security portion listed as an OASDI contribution standing for Old Age, Survivor and Disability Insurance. As the acronym implies, this tax represents the credits you are paying into the Social Security system for your future. Your Social Security credits are placed in an overall pool for the benefit of current retirees, disabled individuals and survivor’s of people who have passed away.
Social Security - 6.2% - OASDI for Old Age, Survivor, Disability Insurance. 6.2% of your paycheck is taken out as part of the FICA tax. This represents the credits you pay into the Social Security system to receive a Social Security Benefit in retirement or if disabled.
Social Security is considered an insurance program for most workers in the U.S. In order to be “fully insured” you have to pay in, or have these FICA amounts taken out of your paycheck for a total of 40 quarters, or 10 years. Once an individual has paid into the Social Security system for a total of an aggregate 10 years, they are considered to be fully insured and would receive their full Social Security benefits at retirement or if they become permanently disabled. Social Security benefits in retirement are capped at $45,000 per year for someone at the highest FICA tax base levels of $142,800 in 2021. Income over the maximum base of $142,800 does not currently have FICA taxes withheld. So if someone makes 175,000 in 2021, the 7.65% FICA taxes are only taken out on the first $142,800 in earnings. After this amount, currently no FICA taxes are withheld. To review how much you have paid into the Social Security system and to confirm your records match check out SSA.gov.
*While most workers in the U.S. will be eligible to receive Social Security benefits, oftentimes federal or state employees do not pay FICA taxes and are therefore not eligible for Social Security benefits. Since these workers commonly have access to other federal or state pension programs and do not pay into the system, they may not have the usual Social Security benefit that most workers come to expect.
In addition to the 6.2% taken out for the Social Security tax, Medicare taxes are also part of FICA taxes. Federal Medicare taxes account for 1.45% of withholdings from your paycheck. Medicare taxes go into the system to help cover the massive medicare costs incurred each year in the U.S. For individuals earning more than $200,000 in 2021 and for married couples filing jointly earning over $250,000 per year, they pay an additional 0.9% from their gross pay in Medicare taxes.
When it comes to money taken out of your paycheck most people think of payroll taxes first. Unlike your FICA taxes which are a set 7.65% of your gross earnings, you have the ability to set your income tax withholdings for state and federal.
When starting a new job, your HR department will have you complete a W-4 tax withholding form to specify how much of your paycheck you would like your company to send to the IRS on your behalf. Whether you have a refund, or owe taxes when tax day rolls around largely depends on how much you had your company set aside in withholding. Too little withholding and you may have to pay more in taxes, too much withholding and you’ll receive a refund. While it’s nice to get a refund, it’s important to note that a refund means you gave the federal government an interest free loan for months. In general, most accountants will say it’s best to be as close to owing $0 as you can on tax day.
The IRS recently updated the tax withholding guidelines so it is recommended for everyone to review their current tax withholding and visit the IRS’s tax estimator tool. The new withholding process tripped up many people when filing taxes in 2020 who found out they owed thousands in additional taxes. If you have not reviewed the updated W-4 guidelines, contact your HR department or take a look at the new IRS tool.
In addition to the Federal Withholding, most states also have a state income tax withholding. States have various ways of calculating state income taxes—some states have a progressive marginal income tax system similar to Federal taxes. Other states have a flat tax, while a few states such as Florida and Texas do not have state income taxes at all. The percentage taken out for state income tax withholding does vary. Contact your HR department to confirm the withholding percentage for your state. If you owe a sizable state income tax bill when filing taxes, you may want to check with your Human Resources office to see about increasing your withholding, if applicable.
You may also see a Local or City tax taken out of your paycheck depending on your city of residence. This tax is generally a flat income tax, but it can also vary.
A few states, such as California, also require a withholding from your paycheck to cover a partial disability insurance for California residents. Not to be confused with state unemployment insurance, which is paid for by your company, state disability insurance is set up to cover some benefits in the event of your disability.
We did not mention other withholdings you may see if you are enrolled in a company or employer sponsored retirement plan, such as a 401(k) or 403(b) plan. You will also see your deferrals for your retirement program taken out of your paycheck as well. The amount of the deferrals are under your control whether you’d like the amounts to be a flat amount or a given percentage of every paycheck.
If your employer has a matching program for your retirement plan, you may see any contributions they make on your behalf reflected on your pay stub as well. Employer contributions are often, but not always, a benefit of working at that employer set up to encourage you to save for your retirement. Oftentimes you must be eligible, enrolled and contributing to your 401(k) plan in order to receive any matching contributions from your company. If you do have an employer match available, you should consider enrolling and contributing to your plan to at least meet the match. After all, it is generally a steady percentage of your paycheck (often between 2-5%) and it’s free money! Before making any changes to your personal situation, it is always advisable to speak to your qualified tax professional or other financial professional about your particular situation.
If you have a Health Savings Account (HSA) option tied to your health insurance plan and you set aside money from your paycheck to contribute to this health savings account, you would see that deferral on your paycheck as well. Some companies offer short or long term disability benefits, group life insurance coverage, long-term care insurance, visions insurance, dental insurance and various other benefits. Any premiums you pay for these programs will be reflected on your pay stub as well.
If you have questions about the details on your pay stub, contact your Human Resources department or payroll provider to get a full breakdown of your withholdings and benefits.