Not all dollars are taxed equally
In case you’ve ever been curious about all that information on your paystub (because maybe you couldn’t sleep one night and needed something to think about), here’s a quick intro guide on what many of those data points are showing!
In this blog post I specifically want to highlight how your dollars are taxed. They’re not all taxed equally, and that is often surprising for people to learn. I know it was for me! At least being somewhat familiar with the concepts here can be helpful during our financial planning conversations. And who knows, you might be able to help a friend, co-worker or family member unravel their paystub after reading this 🙂
How are the ways in which dollars are (generally) taxed/not taxed (this is written assuming you have a W-2 job). State taxes have been excluded from this post.
Terms to know:
Deductions: Amounts that reduce your gross pay. They can be pre- or post-tax.
FICA Tax: Federal Insurance Contribution Act. It’s the combination of Social Security and Medicare. The Social Security portion of FICA is 12.4% of your pay. As the employee, you pay 6.2% of that and your employer pays the other 6.2%. The Medicare portion of FICA is 2.9% of your pay with half of that (1.45%) being paid by you as the employee and the other 1.45% paid by the employer. Self-employed individuals pay both employee and employer portions. There is an additional Medicare tax for some higher income earners.
Federal Income Tax: The amount of income tax you owe at the federal level, based on our progressive tax system.
Gross Pay: Your gross pay (sometimes referred to as before taxes) is what you earn BEFORE any taxes or deductions are taken out. This is often the number you’re quoted upon being hired or getting a raise. It’s easy to forget about this number because we are more familiar with our net pay (sometimes referred to as after taxes), which is the amount that lands in our bank account every time we get paid.
Net pay: Gross Pay – pre-tax deductions – post-tax deductions – taxes = net pay
Taxable Income: This can refer to the income that is taxable for the purposes of FICA and/or Federal and State Income Tax. It’s this definition that we’re attempting to clarify here in this article.
Let’s talk about the deductions that take place BEFORE FICA is calculated (pre-tax deductions):
Most employer-sponsored health insurance premiums that employees pay through payroll are pre-tax. This means they are deducted BEFORE any taxes are calculated, to include FICA.
So if you have $5,000 of gross earnings this month, and your health insurance premium is $200, your earnings for purposes of figuring FICA taxes, federal and state taxes have now been reduced to $4,800. Reference the charts below for examples (on an annualized basis).
HSA, FSA, and medical/dental plan premiums are also pre-FICA deductions. Not only are these examples not subject to FICA they are also NOT subject to federal income taxes.
Then there are some deductions that are NOT subject to federal income tax, but ARE subject to FICA:
If you have a workplace retirement account such as a traditional 401k, and you contribute to it, the dollars you contribute are not taxed for federal income tax purposes. These contributions ARE subject to FICA Taxes. In fact, when you review your W-2 at tax time you’ll notice the amount listed in box 1 (Wages, Tips, Compensation) is your gross wages minus whatever amount you contributed to your traditional 401k (and other contributions, for example to an HSA if you have one); but in boxes 3 and 5 (Social Security and Medicare Wages) you’ll see a different number – this number reflects contributions to a 401k since those contributions are subject to FICA.
| These deductions are generally considered “pre-tax” and are excluded from the following taxes: | ||
| PRE-TAX DEDUCTIONS: | FICA | Federal |
| Employee paid health insurance premiums | Yes | Yes |
| HSA | Yes | Yes |
| FSA | Yes | Yes |
| Vision/Dental | Yes | Yes |
| Traditional 401k Contributions | No | Yes* |
| Roth 401k Contributions | No | No** |
*Traditional 401k contributions are tax-deferred. This means you do not pay taxes on the contributions in the year in which you make the contributions, and those dollars continue to grow tax free until you begin to make qualified withdrawals from the account. It’s at the time of making a qualified withdrawal that you will pay federal income tax.
** Roth 401k contributions are considered after-tax dollars because you pay taxes in the year in which you make the contributions. Because you’ve already paid federal income tax on these contributions, you will not have to pay federal income tax on those dollars upon withdrawal.
Finally, there are deductions that are made AFTER all taxes have been calculated. These are your post-tax deductions.
| POST-TAX DEDUCTIONS |
| These deductions are considered “post-tax” deductions. Meaning FICA and Federal Income Taxes are calculated BEFORE these deductions are made. |
| Supplemental life insurance |
| Disability Insurance |
| Group Legal Plan |
| Roth 401k Contributions |
Here are some examples of how that all works:
PRE-FICA:
| Gross Pay | $100,000.00 |
| Deductions taken before FICA tax is calculated | |
| Employee portion of Health Insurance Premium | $2,000.00 |
| HSA or FSA Contribution | $1,200.00 |
| Vision/Dental Plan Premium | $600.00 |
| Total amount not subject to FICA | $3,800.00 |
| Wages subject to FICA (often reflected in boxes 3 & 5 of your W2) | $96,200.00 |
| The employee portion of Social Security tax at 6.2% and Medicare tax at 1.45% are calculated off of $96,200 and not $100,000 in this example. | |
| *All numbers are annual | |
PRE-FEDERAL Gross Pay |
$100,000.00 |
| Deductions taken before federal income tax is calculated | |
| Traditional 401k Contribution | $10,000.00 |
| All pre-Fica deductions listed in table above | $3,800.00 |
| Total amount not subject to federal income tax | $13,800.00 |
| Wages subject to federal income tax (W2 Box 1 Wages) | $86,200.00 |
| Federal Income Tax is calculated off of $86,200 and not $100,000 | |
| *All numbers are annual | |
AFTER-TAX DEDUCTIONS Gross Pay |
$100,000.00 |
| Less pre-tax deductions | $86,200.00 |
| Deductions taken after taxes have been calculated | |
| Roth 401k Contribution | $10,000.00 |
| Supplemental Life Insurance Premiums | $100.00 |
| Disability Insurance Premiums | $400.00 |
| Taxes withheld (FICA, Federal, State) … an arbitrary number is used here just to illustrate the process – it is not reflective of the calculations above | $2,000.00 |
| Total amount of after-tax deductions and taxes | $12,500.00 |
| Net Pay that lands in your bank account | $73,700.00 |
*All numbers are annual Hopefully you found that to be a helpful explanation of how dollars are taxed differently (assuming a W2 paying job). There are so many different benefits at your job from health insurance, to saving on taxes that it can be helpful to reflect from time to time on just what it is exactly you’re getting from all that hard work! |
