Paycheck questions? You’re not alone! For example, over half of Americans don't know the difference between HSA and FSA, according to a poll taken by Bend Financial. Luckily, today we have some help from two payroll and accounting experts from Addition Financial, Brandon and Andrew!
Randy asks Question 1: “Can one of you explain the difference between gross and net pay?”
Andrew responds: “The gross pay is that larger amount that you see on your pay stub. There are two ways to calculate that. If you're an hourly employee, that's the number of hours you worked times your hourly rate. If you're a salaried employee, that's your annual salary divided by the number of pay periods. So if you get paid bi-weekly there's 26 pay periods.”
Cristina asks Question 2: “Can you give us an example of the types of paycheck deductions?”
Brandon responds: “With deductions, you pretty much are in two categories. You have mandatory deductions and voluntary deductions. Your mandatory deductions are going to be your taxes that everybody has to pay. You have your federal income tax and you have your FICA taxes, which is your Social Security and your Medicare tax. Those are all considered mandatory no matter what. Another thing that's considered a mandatory deduction is whenever you get garnished by the government. So child support, alimony, anything that is actually sent to you with a judge's signature that is considered a garnishment. That is mandatory, it has to come out every paycheck.”
Brandon follows up: “Now voluntary. Those are like your medical insurance that you pay, the dental, your retirement funds that you’re going into. So 401K, 457B if you're making a whole lot of money, IRAs, and all that stuff. So those are kind of along the lines of what a normal deduction you'll see on your paycheck.”
Randy asks Question 3: “Brandon, what is a W-4 form? What are some common mistakes people make when filling them out?”
Brandon responds: “So the W-4 form itself is actually one of the first pieces of material that you're filling out when you actually start your job. When you fill out this form, the company that you're working for is either doing it themselves or providing it to their payroll provider that they work through – companies like ADP, Paylocity, and a couple other companies out there, they’re going to use that information and map out how much tax withholding that you should have per paycheck for the whole year. That’s why the W-4 is very important and the reason to make sure that you actually put the information on correctly. You can either take too little taxes out, or you can have way too many taxes coming out, where you're actually giving the government more of a loan.”
Brandon follows up: “Some of the mistakes that people make is that they're not filing their situation correctly. Obviously, if you're single, then it's very easy. You check the box ‘single,’ and that’s pretty much all you almost have to do, and then sign the form. It gets a little bit more complicated whenever you're married. At that point, you can either decide to file jointly, where you both actually team up together, or file separately. Filing separately gets to be kind of like where you'd be single. But another issue with the W-4 is whenever you get to have dependents, if you have children.”
Brandon follows up: “There are tax deductions for having a child, or having somebody that you take care of pretty much fully – if you have an elderly grandparent or anybody else that is dependent on your care, you can get a tax deduction when it comes to that on the W-4. The main problem is that people fall into an issue whenever they have a life-changing event like getting married or getting divorced, and they don't make that change automatically with their company - they don't file a new W-4. At that point, your tax is just going to be off by the time you get to the end of the year, where you actually might have to pay a lot more taxes. Nobody wants to see that extra money coming out of your pocket.”
Cristina asks Question 4: “Can you please clarify the difference between an HSA and an FSA?”
Brandon responds: “An HSA is what they call a health savings account. Then, an FSA is what they call a flexible spending account. There's a lot of really good things with both of them. They both should be used strictly to cover medical expenses. Now, the difference that you will have between the two, is that with an FSA, you can only spend it within that year that you take that out. You cannot have both an FSA and a HSA at the same time.”
Brandon follows up: “An HSA, some people use it as almost an extra savings account, an extra retirement account that you can use whenever you get up into 65 and up. Then at that point, these are all pre-tax dollars and you can actually use it for medical expenses all the way through. So this money, it comes off that gross pay, where you actually will see that money be used a little bit easier without Uncle Sam having his fingers in the pot.”
Randy asks Question 5: “What are tax brackets and what do they mean?”
Andrew responds: “The United States uses a progressive tax system. The first bracket is $0 to $11,000, you'll be taxed at 10%. So, any money you make over that will be taxed at the next bracket. No matter if you're making $50,000 or $100,000, your first $11,000 of income will be taxed at that same tax rate. There's definitely tiers moving forward. So, from $11,000 to $44,000, you get taxed at 12%. Then, $44,000 to about $95,000, you’re taxed at 22%. It kind of depends on how much you make. Then, that'll give you an effective tax rate. And that's the actual amount that you will be paying.”
Randy asks Quick Question 1: “Is there anything listeners can do to maximize their earnings per paycheck?”
Andrew responds: “I think a lot of personal finance questions come down to if you build a budget. If you know what expenses are coming out, you could kind of tailor your paycheck to go to certain accounts. If you know the amount you're paying on monthly expenses, you could cover that portion from your direct deposit to your checking account. Then, if you have excess money, you don't want it just sitting in a low yield checking account. You can move that money to maybe a high yield savings account or some investment accounts.”
Andrew follows up: “At Addition Financial we have high yield money market accounts. They're also liquid, so you could pull money if you need to take money out, but they earn a good interest rate. Then, we also have a high yield savings account up to $5,000.”
Cristina asks Quick Question 2: “Do bonuses get taxed differently than regular pay?”
Brandon responds: “Yes they do, and no they don't. It really depends on when the bonus happens. Yes, they do get taxed differently whenever it's a thing called the percentage bonus method. This is whenever it's an actual separate check from your regular pay. If you do get paid bi-weekly, this would be like in that week in-between. This is an off cycle payroll. It's usually strictly for executives. That's what they call the percentage bonus method. Whenever that happens, it's a flat rate of 22% up to $1 million. Above $1 million is 37%.”
Brandon follows up: “No is whenever the bonus is tied along with the same time as your regular paycheck. Then at that point, it's a little bit more complicated. They actually add the bonus along with your regular pay, and you get taxed at whatever that dollar amount would be. So, it could be higher going the percentage bonus rate, or sometimes it can be lower. It really depends.”
Randy asks Quick Question 3: “How does contributing to a 401k affect my taxes?”
Brandon responds: “So with a 401K, these are what they call pre-tax dollars. Everything that you contribute to your 401K, which I believe right now it's $23,000 for 2024, is the max contribution rate. You have a catch up that you can use if you're over the age of 55, which is around $7,000 or $7,500 for 2024. Every dollar that you spend in your 401K, or that you contribute to your 401K, that is money that Uncle Sam cannot touch. It takes it right off what they call your taxable income. And that's where everything that your federal income tax, your Medicare, your Social Security, that money comes off your taxable income.
Brandon follows up: “So, by contributing that to your 401k, you're providing a better chance of paying costs and everything else in the future when you get up in your 60s, 70s, 80s. You get more value of your money over the course of your career. Contribute as much as you can to your 401k as early as you can. Then, at that point you see the benefits of a good retirement.”
Cristina asks Quick Question 4: “How can we make sure we’re not overpaying or underpaying our taxes?”
Andrew responds: “If you look at prior years, if you had a big refund or if you owed a lot of money to the government, that's one indicator that will tell you if you're overpaying or underpaying throughout the year. What Brandon alluded to earlier, life altering factors. If you get a new job, higher income, or you get married, those are also factors that you kind of need to be aware of. Make sure you make those changes to your W-4 to make sure that the taxes that are coming out will be in line. And then the IRS has a withholding estimator. If you want to kind of try to estimate on their website, estimate what you should be paying and adjust your W-4 accordingly.”
In this episode, Cristina and Randy highlighted our post, The Expert Bi-Weekly Budget and Savings Plan. Understanding your paycheck is step one, but it’s how you use it that matters!