Gross Pay vs. Net Pay: What's The Difference?
- Gross pay is what employees earn before taxes and payroll deductions are taken out of their paychecks.
- Net pay ends up in your pocket after the deductions are taken from your paycheck.
- Many factors contribute to the deductions listed on your paycheck, including the government and your employer.
You’ve probably heard the terms gross income and net income tossed around. But if the technical terms for these simple concepts confused you, then let’s clear it up.
Gross pay is your total earned wages that you get from your employer. When your contract says that you will be paid $50,000 yearly, that is your gross pay. Net pay includes the payroll deductions that are taken out of your paycheck. Net pay, also known as take-home pay, is how much ends up in your bank account at the end of each pay period.
Visual Example of Net Pay
Let’s put net pay into a visual picture. Imagine someone throwing your clothes off a building, and you’re trying to catch them with a net at the bottom. Other people, like the government, your employer, and insurance companies, are higher up than you are and will catch some of those clothes before it lands in your net. The clothes the other entities didn’t catch are your net pay—because the rest of the clothes have landed in your net.
Now that we understand the basics, the question is, why don’t you take home as much as you “make” on paper? Who decides how much is deducted from your paycheck? What is being deducted? Answering those questions clearly and simply will be the focus of the rest of this article.
Deductions Decision Makers
There are a lot of different factors that go into your deductions. Below is a list of deductions taken from your paycheck by various entities.
The federal government taxes your paycheck for various taxes at a certain rate, like social security and healthcare. That means a certain amount of your paycheck will always be deducted for taxes.
The next decision maker on deductions is your employer. Your employer plays a role in deciding health insurance premiums, complying with legally required deductions, and incentivizing you to deduct from your own account.
Lastly, the employee is a major decision-maker on deductions. While the government has certain percentages they will take, you have to report to them using an Employee’s Withholding Certificate or a W-4 form. This form will let the federal government know how much they should deduct from your paycheck.
You get a tax return if you deduct too much because you overpaid. But, on the other hand, if you deduct too little, you can get fined by the Internal Revenue Service (IRS). So, talking to a tax professional is important to get your paycheck taxed correctly.
As an employee, you decide how much to withhold from your paycheck for retirement contributions or other deductions agreed upon with your employer. In other words, you, your employer, and the government are playing a balancing act of decision-making to decide how much will be taken from each paycheck.
What exactly are you balancing, then? Let’s dive into what get’s deducted from a paycheck.
Paycheck Deductions Explained
1. Income Tax Withholdings
The first thing that gets withheld from your paycheck is the income tax. This is what the W-4 form is for. The dependents, credits, and adjustments you claim on this form determine how the tax rate is applied to you.
The W-4 form is for Federal Income Tax Withholdings. However, depending on your state, you may also have State Income Tax Withholdings. The State Income Tax varies depending on the state and is deducted directly from your paycheck.
2. Payroll Taxes: Social Security and Medicare Taxes (FICA)
Per the Federal Insurance Contribution Act (FICA), you also contribute to Social Security and Medicare in what is called the payroll tax. So, to be clear, if some say “FICA,” “Payroll Tax,” or “Social Security and Medicare Tax,” they are all the same thing.
This is a fixed percentage of your income split between you and your employer. So you pay half of the tax, and they pay the other half.
Recommended Reading: How Payroll Withholding Helps and Affects your Pay
3. Employee Contributions to Retirements Accounts
Next, we have retirement contributions to accounts such as a 401(K), a 403(b), or an Individual Retirement Account (IRA). These plans are called “defined contribution” plans because they depend entirely on what you contribute to the plan. These contributions are up to you and deducted directly from your paycheck.
These can be tricky to understand, but here are a few things to keep in mind.
- If you contribute to a traditional retirement account, that will lower the overall amount you owe in taxes to the government for that year.
- If you contribute to a Roth IRA account, you will still pay taxes on those contributions, but not when you spend them in retirement.
- Another thing to keep in mind is that an employer match is not deducted from your account, but it is an incentive they offer to encourage you to contribute to your own retirement.
Recommended Reading: 401K Vs. IRA: Which One Should I Choose?
4. Health Insurance Premiums and Contributions
Health insurance premiums are also taken from your paycheck. So, while you can choose between the offered plans, you have little control over how much is being deducted from your paycheck for healthcare. But, if you have a Health Savings Account (HSA) plan option, you can contribute to that which, like a traditional retirement plan, reduces how much you owe in taxes.
5. Wage Garnishments
A court order could lead to wage garnishment if you owe money for child support, taxes, defaulted loans, or several other things. That means those debts are paid out of your wages.
These are the main deductions you may see that lead to your net pay being less than your gross pay. There are other deductions out there, but they are less common. For example, teachers might have wages deducted throughout the school year to get paid during the off-contract months of June and July. These types of deductions, however, are between you and your employer.
The Money Wrap-Up
Now that you understand the difference between gross pay and net pay, you can start to think about how you can shift your net pay to meet your needs. Ask yourself the following questions to help you understand what you may need to change regarding your paycheck deductions and contributions.
- Do you need to catch up on retirement and lower your tax bill? Then, you can contribute more to your traditional retirement accounts.
- Are health care costs taking too much money? Then, you could open an HSA.
- Are you getting a huge tax return with money that you could better use throughout the year? You could change your W-4 form.
By understanding the deductions included in your net pay, you have more power to shift it to your advantage.