You just started working at your first job and you are excited that you are now an earning, tax-paying, responsible adult.

Truth be told, you aren’t really excited about the taxes part, but still, you can’t wait to receive your first salary and do some of the things you have been waiting to do – take your friends out, buy yourself some nice clothes, or buy your mom a present – with your own money.

Who knows, in a year or so, you might even have saved enough for a holiday or your own car.

When your first paycheck arrives, however, a wave of shock and disappointment hits you. This is not what you expected.

It is unbelievable!

Sure, you have still received quite a bit of money, but there is a problem… it is less than you were promised when getting hired.

With the amount you are receiving, it will take you much longer than you had expected to save for that vacation. Is your employer robbing you?

Before you rush to the HR office screaming bloody murder, you need to understand that there are deductions that are made to your gross salary, meaning that the amount that finds its way to your bank account will be significantly less than you expected.

In today’s article, we are going to look at six deductions that end up making your paycheck smaller than you expected.

NET PAY IS DIFFERENT FROM GROSS PAY

In the United States, no federal laws dictate that financial literacy be taught in schools.

This is in contrast with countries like the UK, Singapore, and Australia.

As a result, many young people do not understand many of the deductions on their paycheck, or the fact that these deductions, such as 401(k) contributions, are actually good for them down the line.

When you got the job and they told you that your salary would be a certain amount, they were probably talking about the gross pay.

However, this is not the amount you will receive in your bank account. The amount you receive after deductions have been made is known as the net pay.

Put simply, gross pay is the total amount your company pays you before taking out taxes and deductions.

Net pay is the amount they actually deposit into your bank account. For instance, if you have an annual salary of $35,000, it might translate to an annual net pay of $28,000 (if we assume a 20% tax rate and no other deductions).

This means that by the end of the year, you will have received a total of $28,000 in your bank account.

In other words, you should not budget for $35,000 as that would mean a deficit of $7,000 in your budget. It’s best not to make a conclusive budget before you get your first paycheck. Make a tentative and conservative budget which has room for flexible adjustments.

When your first paycheck arrives, adjust the budget to suit the amount you actually get.

This will save you from disappointment and also help you save money.

That means that you should not commit to buying anything until the first paycheck arrives and you are sure what tax bracket you are in and the deductions on your salary.

Otherwise, you might end up committing to installments that you can afford on your gross salary but not on your net salary.

This is an easy way to get yourself in debt when you have just started getting paid, which would be a bad precedent for your financial future.

Note that in the example above, we did not factor in other deductions such as FICA, Medicare, or 401(k) contributions, so the net pay will be even smaller than you expect.

Remember that even the benefits or bonuses you receive (for instance, the sign-on bonus) come with their own deductions.

A lot of financially smart young people forget to account for these deductions and are surprised when their first paycheck is smaller than what they calculated.

Below, let’s take a look at six major deductions that you will find on your paycheck.

1. 401(K) AND 403(B) CONTRIBUTIONS

401(K) Plan

The 401(k) refers to a retirement savings plan which your employer sponsors for your benefit. It enables you to save and invest a portion of your monthly paycheck before taxes and other deductions.

Taxes are only paid after the 401(k) amount has been deducted. In other words, the money that goes to your 401(k) plan is untaxed. You only pay taxes on your 401(k) when you are withdrawing it (in retirement).

The future is uncertain and unpredictable. Working for today only is dangerous and irresponsible, especially if you have dependents.

The 401(k) enables you to safeguard your future, allowing you to have a comfortable life after you have retired and are not earning anymore.

The name “401(k)” is derived from the section of the tax code that governs 401(k) plans. These contributions were introduced in the 1980s to supplement workers’ pensions.

Back then employers offered pension funds to their employees, which they paid out over the course of an employee’s retirement.

However, due to the escalating cost of running pensions, employers opted for 401(k) plans instead.

The 401(k) gives the employee control over how his/her money is invested.

Most 401(k) plans provide a spread of mutual funds such as bonds, stocks, and money market investments.

The most popular investment is typically target-date funds, which combine stocks and bonds that over time become more conservative as you approach retirement.

Note, however, that the 401(k) comes with restrictions and caveats. In many cases, you are not allowed to access the employer’s contributions immediately (many employers offer a benefit where they match your 401(k) contributions).

There is a particular amount of time you are required to work for the company before you can have access to the payments your employer has made to your 401(k) – this is known as “vesting”.

However, your own contributions vest immediately.

The fact that you can’t tap into your employer’s contributions right away is an insurance employers put in place to ensure new employees do not leave the company early.

In addition, there are complex rules governing how much money you can withdraw.

Furthermore, there are costly penalties for withdrawing funds from your 401(k) before you attain retirement age.

For the task of overseeing employee 401(k) accounts, companies typically hire administrators, such as Fidelity Investments, who will update you via email on the state of your plan, its performance, manage paperwork, and so forth.

How much should you decide to put in your 401(k)? Since you will need money to live, eat, and spend after retirement, with a likelihood that you may not have another source of income at that time, it is good to put in as much as you can afford.

You should invest at least enough to get the full matching amount which your company pays into your 401(k) to match your contributions.

This is like free cash and you should not leave any of it on the table. Almost all 401(k) plans offer matching funds – 3% of your salary is the most popular one.

A 3% employer matching program translates to the employer being ready to pay an amount equal to (at most) 3% of your income into your 401(k).

Since the employer is matching what you put in, ensure you don’t put in less than 3% of your income as that would be tantamount to leaving free money on the table.

You are of course free to put in more than 3% in your 401(k).

403(B) Plan

Like the 401(k), the 403(b) is a retirement plan. The difference between them is that the 403(b) is designed for specific employees of tax-exempt organizations, public schools, and certain ministers. 401(k) plans, on the other hand, are available to any eligible employee in the private sector working for a company that has a plan.

403(b) plans can invest either in mutual funds or annuities. 403(b) plans are tax-sheltered annuity plans. Its features are similar to those of a 401(k) plan.

Individual 403(b) plan accounts include an annuity contract (bought via an insurance company) or a custodial account (invests in mutual funds) or a retirement income account for church employees. People who work in tax-exempt organizations are eligible for a 403(b).

Examples include nurses, librarians, school administrators, doctors, teachers, government employees, and professors.

As is the case with 401(k) contributions, your 403(b) money is tax-deferred until you withdraw it. Furthermore, just like with the 401(k) employers can match employee 403(b) contributions. Withdrawing from your 403(b) before you are 59.5 years old makes you incur a 10% tax penalty.

You can avoid this penalty under some circumstances – for instance, separating from your employer when you reach age 55, disability, a qualified medical expense, or death.

A 20% federal income tax withholding is imposed on 403(b) withdrawals – unless you transfer the total amount another qualified retirement plan or an individual retirement account.

2. FEDERAL INCOME TAX

A portion of your income has to go to the government in form of tax. Taxes help run the government, which is why it is important for every earning adult to pay their taxes – they keep the country going.

The federal income tax is levied on your annual earnings by the US Internal Revenue Service (IRS). The money is used to pay for the country’s growth and upkeep.

A good analogy you can use to understand why paying this tax is necessary is to compare it to a rent that you are charged to live in the country and use the resources your government or country provides.

Income tax is calculated by multiplying the tax rate with your taxable income. Taxable income is not the same as gross income. Remember that we mentioned your 401(k) deductions are not taxed.

Therefore, taxable income is defined as gross income less the allowable deductions. Income tax is also deducted from cash gifts from your employer, tips, business income, bonuses, gambling income, and unemployment compensation.

The federal income tax is part of a progressive tax system.

That means a higher tax rate is imposed on people who earn a higher income. In other words, your tax rate is based on your ability to pay.

The idea behind this progressive tax system is that lower income earners need more of their income to survive and afford basic necessities.

Furthermore, low-wage earners are likely to spend all of their money, which stimulates the economy.

The government determines how much tax you should pay by dividing your taxable income into tax brackets, with each bracket getting taxed at the corresponding rate.

There are seven federal tax brackets in the US: 37%, 35%, 32%, 24%, 22%, 12%, and 10%.

The first tax bracket has a tax rate of 10% of any income between $0 and $9,700.

The second tax bracket means you owe a tax amounting to $970 plus 12% of the amount over $9,700.

This goes on as you climb higher up the tax brackets. You can see the rest of the 2018-2019 tax brackets and federal income tax rates here.

It’s important to use the IRS Withholding Calculator to find out if the correct amount of tax is being withheld from your paycheck.

Doing this ensures you are not withholding too little tax as this could lead to an unexpected tax bill or penalty hitting you in the next year at tax time.

If it turns out you are withholding too little tax, you need to fill out a new Form W-4, Employee’s Withholding Allowance Certificate, using the results from the Calculator to adjust income tax withholding.

3. STATE AND LOCAL INCOME TAXES

While federal income tax goes to the federal government, the state and local taxes are similar deductions on your income which your employer sends to the state, city, or county revenue division.

How much you pay in state and local income taxes depends on your income level and on the tax rates of your state or municipality.

Not all states have state-level or local-level individual income taxes. Some states have neither state-level nor local-level individual income taxes.

Some states have state-level income tax but no local-level income tax. Some states have both state-level and local-level individual income taxes.

Examples of states that have local income taxes are Alabama, California, Colorado, Delaware, Indiana, Iowa, Kansas, Kentucky, New York, and New Jersey.

The taxes are typically imposed at a flat rate, applying to a limited set of income items.

4. MEDICARE

Medically is a legally required deduction which is listed under FICA (Federal Insurance Contributions Act), a US federal payroll tax.

FICA includes Medicare and social security tax, and is deducted from each paycheck. Your FICA payment will depend on your income – the higher your income, the higher your income payment.

FICA contributions are compulsory. The rates are set annually – but that does not necessarily mean they change annually. For instance, they were stable from 2018 to 2019.

Medicare is a US nation-wide health insurance program which ensures Americans aged 65 and older have health insurance.

It also caters for younger people who have some disability status and people who have end stage renal disease or amyotrophic lateral sclerosis (ALS).

In other words, paying Medicare today will ensure you have health insurance when you are a senior citizen. Health is one of the most precious things, and in old age it becomes highly elusive.

Without insurance, growing old and retiring can turn into a nightmare as you have no money to pay for your health expenses.

Medicare contains four parts. Part A is Hospital Insurance. Part B is Medical Services Insurance. Part D covers a variety of prescription drugs, some of which are covered by Part B. Part C is Medicare Advantage plans.

Medicare covers, on average, about half of your healthcare expenses once you are 65 years and older. None of the four parts cover all your medical costs – in fact, many costs and services do not get any cover at all.

5. SOCIAL SECURITY TAX

Along with Medicare, Social Security tax is levied on employees and employers as a means to fund the country’s Social Security program. Social Security tax is mandated by the Federal Insurance Contributions Act (FICA), and is collected in the form of a payroll tax.

For those who are self-employed, social security tax is paid under the mandate of Self Employed Contributions Act tax (SECA tax). Self-employed workers pay both the employer and employee portions of FICA, but they do it only on 92.35% of net business earnings.

Social security tax pays for your retirement benefits, disability benefits, or survivorship benefits – services received under the Old-Age, Survivors, and Disability Insurance Program (OASDI).

In fact, OASDI is social security’s official name in the US.

This year (2019), the Social Security tax rate is 12.4% – it is divided evenly between you as an employee and your employer on a maximum wage base of $132,900.

Not everyone pays Social Security tax.

Some groups, for instance nonresident aliens and certain religious groups with specific views, are exempted from making social security contributions.

Non-resident aliens are people who are not citizens of the US, but are also not legal residents, for instance those who are temporarily in the country to study. Some nonresident aliens work in the US for a foreign government, and are exempted too.

Unlike federal income tax (which we established is progressive), Social Security tax is a regressive tax, which is the opposite of progressive. It means that a larger amount of lower-income earners’ income is deducted as tax than that of higher-income earners.

For instance, if you earn $85,000 this year (2019), 6.2% will be withheld from your salary to pay Social Security tax. On the other hand, if you have a work colleague who earns $175,000, the Social Security tax rate will only apply up to a limit of $132,900.

That means this colleague will pay 6.2% of 132,900 rather than the full $175,000.

It means $42,100 of this colleague’s income is not subject to social security tax, while your entire income is taxed. To put it in perspective, this higher-earning colleague’s effective Social Security tax rate is 4.71%, while your rate is the full 6.2%.

6. EMPLOYEE-PAID HEALTH INSURANCE PREMIUMS

If you are fortunate to work for a company that pays for a full health insurance coverage, you will not have any deductions in your paycheck.

On the other hand, if you are paying for a portion or all of your health, vision, or dental care benefits, your share of the cost will be deducted.

Paying for health insurance may seem tiresome, especially when your paycheck turns out to be smaller than you expected.

However, a sudden illness or medical emergency can destroy you financially. Paying for health insurance may be expensive, but the alternative is even more expensive.

Actually, when you are looking for a new job, health benefits is one of the important benefits you should consider.

Does the company provide health insurance? What percentage of the insurance cover is the company willing to contribute? If not enough, can you handle the deductions from your paycheck?

In the Health Insurance Marketplace, plans are typically subdivided into four different categories, such as Bronze, Silver, Gold and Platinum.

Insurance companies offer these four different plans, and employers will use the terms to describe the plans their employees receive. Learn the terminology to ensure you understand exactly what you are getting.

  • The Bronze Plan covers 60% of your health care costs, and you as the consumer are responsible for the remaining 40%.
  • The Silver Plan involves the insurance company paying 70% of the costs, and you paying the remaining 30%.
  • The Gold Plan splits the health care costs at a ratio of 80% to 20%.
  • The best plan is the Platinum Plan, where the insurance company pays 90% of your healthcare costs and you only pay 10%.

Note that the more the insurance company pays out, the higher the premiums you are required to pay.

Clearly, health insurance coverage should be high on your list of priorities when deciding whether to take a job.

The less generous your employer is in this regard, the higher the deductions and the smaller your paycheck will be at the end of the month.

OTHER DEDUCTIONS

You may be paying for other company-sponsored benefits like life insurance or disability insurance.

The premiums for these benefits will be listed as deductions on your paycheck. Some may be deducted before taxes and some after.

WRAPPING UP

While you might be stoked at the prospect of receiving your first paycheck, you should not be surprised when it arrives and it turns out you won’t be able to save or spend as much as you had anticipated.

Instead, you should examine the deductions listed to figure out what you are paying for.

Many of these deductions are useful to you, acting mainly as a safety net.

Old age is inevitable, and who knows what your financial situation will be?

Saving for old age is necessary. In addition, it is important to have insurance cover, both for today and for life after retirement to avoid being brought low by healthcare costs.

And finally, you just have to pay your taxes.

There’s no two ways about it. Like the popular saying goes, there are only two certainties in life – taxes and death.

Reasons Your Paycheck Is Smaller Than Expected

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