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What Is Net Pay?
Net pay is the portion of the salary that an employee “takes home” after all deductions and non-taxable reimbursements have been made to their gross pay. Net pay can otherwise be described as the amount of money that shows up on the employee’s paycheck or in their bank account.
Common deductions include:
- Federal tax deductions
- State tax deductions
- FICA deductions for Social Security and Medicare
- Health, dental, and vision insurance
- 401K contributions, or contributions to other retirement plans (unless they’re considered post-tax deductions in your state)
Net pay can be confusing to employees because they’re expecting their paycheck to reflect the salary or wage they agreed to in the job offer. Instead, they’ll notice that their paycheck is much lower.
If your employee is confused, the best way to explain how deductions lead to net pay is to make sure they understand what each deduction is for, and which ones are required by law. Employees will also benefit from understanding that the company is making deductions on behalf of the employee to either pay the employee’s taxes to the federal government or pay other entities for the employee’s benefit.
Net Pay vs Gross Pay: What’s the Difference?
Net pay is the amount of money that employees receive on their paychecks every pay period. Gross pay, on the other hand, is the total compensation provided by the employer before any deductions are made.
How to Calculate Net Pay
Manually calculating net pay is an extremely time-consuming process and errors are common. Below is our step-by-step guide to calculating net pay correctly. Even with this guide, however, the process will still take a lot of time. If you’re currently running payroll manually, you may want to consider investing in payroll software instead.
Step 1: Calculate Gross Pay
The only way you can calculate the correct net pay for an employee is by first calculating gross pay. Don’t know how? Check out our step-by-step guide.
Step 2: Calculate Taxable Income
The total taxable income, also called adjusted gross income (AGI), is an employee’s gross income minus any pre-tax deductions. Pre-tax deductions are deductions that can be taken out of your income before calculating taxes.
Common pre-tax deductions include contributions for health insurance, dental insurance, 401(k) plans, life insurance, FSA accounts and HSA accounts. Whether a particular contribution is eligible for pre-tax deduction may vary from state to state, so be sure to review any applicable laws in your state.
Example 1: Calculating Taxable Income
What is the taxable income for a person who lives in Wisconsin and has a yearly salary of $48,000? We’ll assume they’re paid the first day of every month and make the following pre-tax contributions:
- Medical Insurance: $120 per month
- Dental Insurance: $25
- 401(k) Contribution: $200
- HSA: $100
Taxable Income Calculation:
- Gross Salary: $48,000
- Gross Monthly Salary: $48,000 / 12 months = $4,000
- Pre-Tax Deductions per month: $120 (Medical) + $25 (Dental) + $200 (401(k)) + 100 (HSA) = $435
- Taxable Income, or AGI: $4000 – $435 = $ 3,565
Although it’s safe to assume that the amount contributed to the HSA in this example did not exceed the maximum allowable contribution, remember that this maximum varies depending on your insurance plan. Also, it just so happens that in Wisconsin, 401(k) contributions can be treated as pre-tax deductions for purposes of state income tax. However, not all states allow this.
Once you have your total taxable income, you can calculate tax deductions.
Step 3: Deduct Taxes from Taxable Income
Once you’ve calculated the taxable income, the next step is to deduct taxes. This includes:
- Federal income taxes
- State income taxes, unless there is no state income tax
- Local income taxes, if applicable
- Federal Insurance Contributions Act (FICA) taxes. (These funds contribute to Social Security and Medicare and 50% must be paid by the employer.)
- State Disability Insurance, if applicable
Federal Tax Deduction
To manually calculate federal tax deductions, you will need the following information:
- Taxable income amount
- Marital status
- Number of allowances claimed on their W-4
Once you have this information, you can use the tables in Publication 15-T to calculate the appropriate withholding amount.
State and Local Taxes
Each state has its own state income tax rules. Resources to help you calculate the appropriate state tax deduction can be found on your state’s Department of Revenue website.
Step 4: Calculate After-Tax Deductions
After-tax (or post-tax) deductions are deductions made after all tax deductions are made. These may include:
- 401(k) contributions (depending on the state)
- Union dues
- Some pension plans
Step 5: Add in Non-Taxable Reimbursements
Reimbursements to employees are non-taxable if they’re a part of an accountable plan. Non-taxable reimbursements often include per diem gas or food, hotel expenses, transportation, or car rental fees. It’s very important that reimbursements that are a part of an accountable plan be calculated and listed separately in the employee’s paycheck so they aren’t incorrectly categorized as income.
The result of these five calculations is the employee’s net pay—and we can all empathize with the fact that it is disappointing compared to the gross pay we might have expected. Hopefully, a clear explanation takes some of the sting away.
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