FINANCIAL FRESHMAN #010
TL;DR → If you want to budget with your future income, you’ll have to make some deductions first. Understanding your specific pre-tax deductions, tax withholdings, and after-tax deductions will help you get a clearer picture of how much money will hit your account with each paycheck.
So, Why Bother?
With a quick internet search, it’s really easy to find paycheck calculators. Most of them are super simple; You input your gross salary, and they’ll spit out a solid estimate of how much money you’ll take home from that salary. Especially if you’re early in your career or still yet to graduate, we would argue that you need to learn where these numbers are coming from.
The foundation of all things personal finance is your budget, and the foundation of budgeting is knowing how much money hits your account every month. There’s a big difference in being able to say “I make $59,000 per year” and “I take home $1,448 each paycheck,” and this article will help you bridge the gap between the two.
Let’s introduce our two graduating seniors, whom we’ll use as examples to carry us through this process.
Understand Your Gross Pay
The starting point, obviously, is understanding your gross pay as well as your pay frequency. Depending on where you are in your college career, you may have different levels of confidence in what this figure may be. Our two example students have already accepted job offers with associated starting salaries, but it’s possible you won’t know those figures yet.
If you’re further away from your full-time career, you should first reference our previous post on estimating your salary after graduation.
The “Gross per Check” value on the right in this table will be the basis for our calculations.
Before-Tax Deductions
Once you have a salary to work with, you should start by brainstorming any deductions that will be taken out of your paycheck before taxes.
Common before-tax deductions include health insurance premiums, as well as contributions to a Traditional 401(k), Health Savings Account (HSA), or Flexible Spending Account (FSA).
For our example, let’s assume that Ryan will contribute 6% to his 401(k), and pay $125 per paycheck for medical, dental, and vision insurance. Casey, on the other hand, will contribute 4.5% to her 401(k) and pay $150 per paycheck for health insurance. Since this is all the before-tax deductions these individuals will have, the resulting figure below represents their taxable income per paycheck.
Federal Income Tax Withholding
From this “Taxable Income per Check” figure, the next step is subtracting amounts to represent federal withholdings, Medicare taxes, and Social Security taxes. Here are the rates we will use:
- Federal Withholdings: 15%
- To keep things simple, we’ll use this percentage for now so we don’t have to worry about applying tax rates, filing status, W-4s, or any of that fun stuff. We’ll cover that another Sunday.
- Medicare Taxes: 1.45%
- This comes directly from the IRS, and is covered on Page 5 here.
- Social Security Taxes: 6.2%
- This comes directly from the IRS, and is covered on Page 5 here.
With these figures in mind, let’s check back in with our two graduates.
State Income Tax Withholding
Next, we can do a similar estimate for the state income taxes owed by these two future employees. It’s valuable to note that income taxes vary wildly by state, both in tax rate and how they are applied. There are also a handful of states with no state income tax at all!
For simplicity here, we’ll make the assumption that both Ryan and Casey will pay 4.5% in state income taxes. If you’d like to reference the specific rules for your future state of employment, check out this summary of 2024 rules by the Tax Foundation.
Let’s check back in with our two students, to further adjust for this additional tax.
After-Tax Deductions
At this point, the final step will be further reducing income to adjust for any after-tax deductions. These could include, but are not limited to, Roth 401(k) contributions, recurring charitable donations, or any employer-sponsored health and wellness initiatives, such as a company gym membership.
Let’s see how these apply to Ryan and Casey.
Now that we’re done with deductions, we can work backwards to calculate the net income of both Ryan and Casey.
Final Thoughts
As you can see, the impact of deductions and taxes is certainly significant, with both Ryan and Casey taking home between 64% and 66% of their gross pay. When it comes to budgeting your future expenses, it’s imperative that you understand the real income that you will see each month.
Use the logic outlined in this article to take your expected salary and make the deductions that will apply in your specific situation. By accounting for income taxes, Social Security, Medicare, and various pre-tax and after-tax deductions, you’ll have a clearer picture of how your earnings will feel.
