What was your first significant money experience outside of your family? For me, it was receiving my very first paycheck.
My initial reaction was, “Hmmm… this is much less than I thought.”
The reality is that many deductions are taken from your earnings (gross pay) before you receive your take-home pay (net pay).
📓 Highlights in this post:
- Your gross pay is not equal to your take-home pay due to deductions.
- You can optimize your taxes by strategically designating your earnings into before- and after-tax deductions.
How is Take-Home Pay Calculated?
Take-home pay (Net pay) = Gross pay – Deductions
What Are the Deductions in a Paycheck?
Mandatory Deductions
Tax Withholding These include your federal and state taxes. While there’s not much you can do to minimize federal taxes, you can consider living in a state with lower income taxes to reduce your state tax burden. I found this Fidelity study helpful. The best states for taxes.
Before-Tax Deductions
This category is crucial because these items are tax-free. Common before-tax deductions include health insurance premiums, traditional 401(k) contributions, Health Savings Accounts (HSA), and Flexible Spending Accounts (FSA). By contributing to these, you can defer taxes (or pay no tax at all) and maximize your tax strategy, particularly for retirement savings. Rule of Thumb: The more you save for retirement (e.g., 401(k) and HSA), the more you can optimize your current tax rate.
After-Tax Deductions
Unlike before-tax deductions, you pay taxes on these items now. Some employers offer retirement savings options like Roth 401(k) in this category. Tax Benefit of a Roth 401(k): You don’t pay taxes on the earnings from your Roth 401(k) in the future, potentially lowering your future tax rate. A Roth 401(k) is often preferred over a traditional 401(k) if you expect your future tax rate to be higher.
