We always talk about how much we make in terms of gross income. However, no matter how much we get paid, the amount that we actually take home always feels too small. To add insult to injury, payroll companies give us pay stubs that are impossible to decipher, and good luck trying to ask your payroll department for an explanation…Understanding the breakdown of your pay stub will help you better understand your tax withholding and optimize your savings. So here is a breakdown of the major items in your paystub, from your gross pay to your take-home income. Everyone is different, so little differences may apply to you.
Health Savings Account Contributions
If you have a high deductible health plan (HDHP) with an HSA account, the first item subtracted from your gross pay is your HSA contribution. If you have an HSA and plan to do any long term savings, you should probably contribute to an HSA as the HSA is the most efficient way to save for future health or other expenses. HSA contributions are subtracted first because they do count as Social Security or Medicare income, and so no taxes are assessed when the contribution is made. You may never owe taxes on that amount if you use it later for health-care-related expenses. This is the key reason that makes the HSA a great vehicle for retirement goals.
Social Security and Medicare (FICA taxes)
On the remaining amount after subtracting HSA contributions, you have to pay Social Security and Medicare taxes. Your portion of Social Security (your employer pays the other half) is 6.20% on the first $147,000 (2022 threshold) you make (after subtracting HSA contributions), and zero after that. So the maximum you are liable for with Social Security is $9,114 for 2022. If you make more than the threshold you may have noticed that your pay stub does not include withholdings for Social Security at some point in the year when you reach the maximum amount. Your Medicare portion is 1.45% of your gross income excluding HSA contributions. There is no cap for Medicare. There is also an additional Medicare tax of 0.9% for people making $200if K single filers, or $250K for married couples ($125K if married filing separately). Your employer may allow you to withhold this additional amount. If that’s the case, you may see an additional item like Medicare Surcharge withholdings, or similar.
Here is an example. Say you are single, make $180,000 a year in gross income, and are paid twice a month, so $7,500 gross every pay period, 24 times a year. You put $152 per pay period in your HSA (this is the max amount for a single, or $3,650 per year in 2022). Social Security and Medicare are withheld on the remaining amount of $7,352, at least until you reach the Social Security cap. Here is a simple table:
| Paystub Item | Amount ($) |
|---|---|
| Gross Income | $7,500 |
| HSA | 152.08 |
| Social Security (7,500 – 152)*6.2% | 455.57 |
| Medicare (7,500 – 152)*1.45% | 106.54 |
In this example, the Social Security cap would be reached in 20 pay periods, by October 31. After that, the Social Security withholdings will be zero.
401(k) Contributions and Other Pre-Tax Items
Your 401(k) contributions come next, if you make them pre-tax (see this post for Roth and after-tax options). For 2022, the maximum amount is $20,500 per year (plus an additional $6,500 if you are over 50). Your 401(k) contributions are subtracted in determining your taxable income. Assuming you contribute regularly to the maximum annual amount, your contribution is $854.17 per pay period. Notice that, unlike the HSA, the amount of 401(k) is taxable Medicare and Social Security income. After your 401(k) contributions are made, you may have other pre-tax expenses. One example is your portion (if any) of your group health insurance premium. Let’s suppose that in our example this amount is $25 per pay period. We can add them to our table.
| Paystub Item | Amount ($) |
|---|---|
| 401(k) Contribution | $854.17 |
| Health Premium | $25 |
Federally Taxable Income
After you deduct HSA contributions, 401(k) contributions, and other pre-tax items like the health premium payment, the rest is subject to federal taxation. In our example, the federally taxable portion is $7,500 – $152.08 (HSA) – $854.17 (401k) – $25 (health care) = $6,468.75. On a yearly basis, that amounts to $155,250. How much of this will actually be taxed depends on individual circumstances: Whether you are married, have dependents, have additional income, etc.
To help you refine your withholding amounts to your situation, you can use the W4 form that you fill out with your HR department. The information you provide helps you, the IRS, and your payroll department to estimate how much you should pay in income taxes over the course of a year. At any time in the year, you can do a tax withholding check-up, to help you set the right amount. Federal income tax is on a pay-as-you-go system. You are supposed to pay taxes as you earn your income to avoid a potential tax penalty.
Assume the single individual in our example does not have any potential credits or deductions besides the standard deduction of $12,550 for 2021. Taxable income would be $142,700. Income taxes would be about $28,269 (24% marginal tax rate), which corresponds to withholdings of $1,177.88 per pay period (assuming 24 pay periods in the year).
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Starting from gross income, how much is the net or take-home pay in this example?
| Paystub Item | Amount ($) |
|---|---|
| Gross Income | $7,500.00 |
| HSA | 152.08 |
| Social Security (7,500 – 152)*6.2% | 455.57 |
| Medicare (7,500 – 152)*1.45% | 106.54 |
| 401(k) Contribution | 854.17 |
| Health Premium | 25 |
| Federal Tax withholdings | 1,177.88 |
| Net Pay | $4,728.76 |
State Taxes?
If you are in a state with state and local income taxes, you’ll have additional tax withholding before you can get to Net Pay. Since different states have different tax treatments and rates, it’s impossible to examine all cases. If you live in Texas, however, you don’t have to worry about these deductions.
The Value of the HSA
We assumed a full HSA contribution in our example. How much would net pay be if we removed the HSA contribution? Three items would be affected: federal taxes, Social Security, and Medicare. Federal taxes would increase by 24% of the amount not contributed, or about $36 dollars for a $152 contribution. The portion of income subject to Social Security (6.2%) and Medicare (1.45%) would also increase by $152 per pay period. Overall, not making the $3,650 yearly HSA contribution would increase net pay by only $2,721. That’s because $929 of the $3,650 is financed by a reduction in payments to the IRS. In other words, it only costs you $2,721 from your net pay to save $3,650 in your HSA account. The value of the HSA changes with your tax bracket and filing status, so it can be larger or smaller, but you can see that the value is nontrivial in most cases.
Restricted Stock and RSUs
When your company compensates you in the form of restricted stock, that is taxable income as soon as the restricted stock vests. When you are granted RSUs, that is not considered taxable income because there is a probability that you may never vest that stock. When it vests, typically your employer deposits the shares in a brokerage account. At that moment, the restricted stock becomes income, and you will see an item in your earnings portion of the paystub, like Restricted Stk or similar. You may still be restricted from trading the stock, but you own the shares now and that is a form of compensation. So, as soon as your restricted shares vest, you will see that as part of your income in your paystub. That income is subject to Social Security, Medicare, and Federal taxes. You will therefore see deductions for these in your paystub. Typically, your company may sell enough of the shares to cover these deductions. The federal portion is typically 22% of the value of the shares. So if your tax bracket is higher, you may owe taxes at the end of the year.
Stock Options
You will not see anything on your paystub when you are granted stock options, even when they vest. When you exercise the options, however, you may see that in your paystub. There are two types of options, Incentive Stock Options (ISO) and Non-Qualified Stock Options (NQS). When you exercise NQS, you will see additional income in your paystub. This is the difference between the value of the shares you acquired (number of options exercised times stock price) and the exercise cost (number of options times the exercise price). This amount will be taxed as ordinary income and so subject to Social Security, Medicare, and Federal taxes. Typically you have options for covering both the cost of the exercise and the federal withholdings (check with your employer or the custodian). So, NSQs are similar to RSUs and you’ll typically see NQ stk options as part of your gross income.
ISOs are a little different, and have a preferential tax treatment. When you exercise them, nothing shows up on your paystub. However, the so-called bargain element, which is the difference between the value of the shares at excercise and the cost to purchase them, is subject to the alternative minimum tax calculation or AMT. If the value is high enough, it may be subject to the AMT. When you then sell the shares, the sale is reported to the IRS and it may be taxed as taxable income. For example, if you exercise shares this pay period and sell them immediately, you will see in your paystub the entire amount of the bargain element as part of your gross income (this would be classified as a Disqualified Disposition, Dsq Disp, or DD or something like that on your paystub). If you sell two years or later after the grant and one year or later after exercise, the amount of the gain is taxed as capital gains. What the gain is may depend on whether the AMT was triggered at exercise or not. It is best to speak with a tax professional about appropriate tax considerations.
Employee Stock Purchase Plan (ESPP)
One more item to consider is contributions to an Employee Stock Purchase Plan or ESPP. Typically, you make contributions to an account that will invest in your company stock at a discount, at some regular frequency. These contributions are part of your after-tax contributions. You will see them under deductions, post-tax. So any dollar you contribute will not change your taxable income for the year. When you sell the stock that you purchase, only the gain from the purchase price will be taxable.
Get a Check-Up, talk to a Fee-Only Fiduciary Desmo Wealth Advisors in Austin TX
We have covered some of the more common items you may have on your paystub, and you may have other elements that can affect take-home pay and taxation. If so, it is a good idea to talk to a professional. Because the federal tax withholding you get from your employer is only a rough estimate, it may be a good idea to check if you are withholding enough towards your yearly liability. We recommend doing it at the beginning of the year, especially if your income may be different from previous years, and later in the year to see if any adjustments need to be made. The IRS has a tool to help you do that. Getting a check-up may help you know if you are likely to get a refund or if you are underpaying. If your situation is more complex, and have equity compensation or other sources of income, you may want to speak with a fee-only fiduciary financial planner to help you maximize the value of your income.
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Hopefully this breakdown will also help you understand where your income is going. The same information in our table is aggregated annually on the W-2 form, which is the first piece of information we look at when we prepare our tax returns. If you are still working on your 2019 tax return, check out this useful guide to tax prep software.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
