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Solving the Mystery of Your Paycheck

If you have ever looked at your paycheck stub and wondered how they get from your gross pay to the considerably smaller number that goes into your bank account, you’re not alone. I have been asked to explain this confusing process many times over the years by bewildered-looking individuals standing in my office doorway with a paycheck stub in their hand. I have also learned that the majority of the people throw the check stub in the trash and don’t look at it at all. Other bolder, more aggressive individuals are determined to understand where their money goes. For those of you in the second category, please read on.
The dentist you work for may have an in-house accountant who prepares your payroll, or the payroll may be outsourced. Payroll outsourcing is just a fancy way of saying that they pay someone else to do it. Employers often choose this option to avoid the headaches of payroll tax reporting. Payroll services will not only process your payroll for you, but they will remit the withholding taxes to the appropriate agency and file the quarterly returns. They will also produce W-2 wage statements at the end of the year. I’m a firm believer in payroll outsourcing, having been responsible for both methods of payroll delivery.
There are many variables and rules for calculations of payroll deductions, so it helps to break them down by categories. Payroll deductions fall into 2 main categories: taxes and voluntary deductions. Taxes are mandatory and based on your tax filing status; voluntary deductions are generally those over which you have at least some control. Let’s look at each category in more detail.

FICA/Social Security

Illustration by Cheryl Gloss

The first type of tax is called FICA and is commonly referred to in aggregate as social security tax. The percentage is the same for everyone, regardless of your filing status. This tax is calculated as 7.65% of your taxable gross and is broken down into 2 parts. The first part is called OASDI, which stands for Old Age, Survivors, and Disability Insurance. This part of the tax is often referred to as social security. This tax is 6.2% of your taxable gross up to a limit of $90,000 of income per year in 2006. The limit increases from time to time, generally when I’m getting close to reaching it. The second part is called MHI, which stands for Medicare Hospital Insurance, and is equal to 1.45% of your taxable gross. This part of your social security tax has no taxable limit. These numbers may or may not be shown separately on your check stub. The taxable gross is your gross pay less any pre-tax deductions, which we will cover under voluntary deductions.

Federal Income Tax

The second required payroll tax is called federal income tax and is calculated based on your tax filing status. The variables here are your marital status, whether you file a joint tax return or file separately, and the number of deductions you claim. This tax is calculated using a tax table that is built on these variables. Generally, the more deductions you claim, the lower your calculated federal tax. You identify your filing status and number of dependents on form W-4, which you are required to fill out for your employer when you start your job. It’s important to put some thought into how you fill out your W-4 form, because it influences how much federal income tax will be withheld from your paycheck during the calendar year.
When you file your tax return for the year, you will calculate your actual tax due and subtract from that any tax that has been withheld from your paycheck and paid to the IRS on your behalf. If you have over-withheld during the year, you will receive a nice refund check. However, if you have under-withheld, you will be writing a check to the IRS on April 15. You will also be charged a penalty if you have significantly under-withheld. The goal is to end up with a very small adjustment at filing time, so you have as much of your income as possible during the year and have little or no tax to pay at the end of the year. There are many things that affect your tax bill at filing time, so when major life changes occur such as marriage, purchase of a home, or the birth of a new baby, you’ll want to revisit the W-4 form and recalculate what your filing status should be.

State Income Tax

Some states also have a state income tax, which like federal income tax, is also based on your tax filing status. Other states opt to have a sales tax instead of an income tax, and some states have both. If you have a state income tax, the same rules apply for figuring out your filing status as you use to determine your federal filing status. If you have a state income tax, you will be asked to fill out a separate withholding form for your state. The person who prepares your tax return is a good resource for help in making this decision.


If it makes you feel any better, you’re not the only one who pays taxes on your income. Your employer pays a number of taxes that are also calculated on your taxable earnings, which are paid to the taxing authorities quarterly.

FICA/Social Security

Your employer makes a matching contribution of 7.65% to the Social Security Administration based on your taxable earnings. The employer’s portion of FICA is broken into 2 parts that are calculated separately, the same as with the employee FICA, because the same limit applies to the OASDI portion of the tax.


FUTA stands for the Federal Unemployment Tax Act. Your employer pays federal unemployment tax on the first $7,000 of your earnings each year. The rate is the same 0.8% for all employers, as long as they stay up to date with their state unemployment taxes. Otherwise, the amount can be increased to as much as 6.2%. This tax is used to fund state workforce agencies and job service programs and also contributes half the cost of extended unemployment benefits.


SUTA is the state version of unemployment tax that your company pays up to the taxable limit of your income each year. The state unemployment rate is different for each employer based upon his or her experience rate. That means the fewer unemployment claims a company has, the lower its tax rate. This tax is also referred to as SUI, or state unemployment insurance, and is used to pay unemployment benefits.

City or Local Taxes

Some areas of the country also have city and/or local taxes imposed on employers based on the amount of their payroll.


Voluntary deductions fall into 2 categories: pre-tax deductions and after-tax deductions. The taxable status depends on the nature of the deduction.

Pre-Tax Deductions

Pre-tax deductions are those that are deducted from your gross pay before your tax is calculated. This means that your taxable gross is lower than it would otherwise be, and therefore your tax will be lower. In order for a deduction to be taken pre-tax, it must meet certain requirements according to the IRS tax code. Contributions made to a 401(k) retirement plan are taken out of your gross pay prior to calculating federal income tax. This reduces your taxable income now, and you don’t pay tax on the earnings until you retire and start taking the money out. If you take money out of your 401(k) plan before you retire, then you will not only pay income tax, but also a stiff penalty. 
Other deductions are taken out of your gross earnings before both FICA and federal income taxes are calculated. These deductions may fall under Section 125 of the IRS tax code and include things like health insurance or deductions that are part of a Cafeteria Plan. A Cafeteria Plan is just what it sounds like; employers offer a variety of pre-tax benefits from which to choose. For example, the portion (if any) of health insurance premiums that employees pay for can be part of this program. Another example is a flexible spending account. This is when employees elect to have money deducted from their paychecks to set aside for out-of-pocket medical expenses. The tricky part here is that you have to be very careful about calculating the amount to be deducted, because if you don’t use the money by the end of the year, then you forfeit it.

After-Tax Deductions

These voluntary deductions are just what they sound like. They are not taken before your taxes are calculated, so they don’t reduce your taxable gross. An example of an after-tax deduction would be an amount taken from your net pay and deposited into your savings account, assuming you have a direct deposit arrangement. Other after-tax deductions could be for employee personal charges made to company accounts, repayment of draws, or amounts withheld from your paycheck to support United Way or other organizations.

Direct Deposit

Direct deposit is the process of transferring your paycheck directly into your bank account. Some employers may give you the option of splitting your net paycheck into 2 or more accounts, depending on how agreeable your accounting department is.


Here’s an example of what a real paycheck stub might look like (see sample check on page 70). Let’s see if it makes more sense now. This is a bi-weekly paycheck, which means 26 pay periods per year. Some companies prefer a semi-monthly pay cycle, which means a paycheck every half-month, so there would be 24 pay periods per year. 

  To begin with, we can see that this individual has an annual salary of $70,000. We know this because we’re looking at a bi-weekly paycheck, so if we take the gross pay and multiply it by 26 pay periods per year, that’s what we get. Notice that the FICA tax is broken down into its 2 parts, and in this example the person has a state income tax. Also note how big that federal income tax number is! They’re going to want to find some deductions before the end of the year.
Now notice the voluntary deductions. Health insurance and parking are part of a Section 125 Plan, which means they are deducted before FICA or federal income tax is calculated. The 401(k) deduction is taken after the FICA tax is calculated, but before federal income tax is calculated. We can illustrate this difference with some calculations. We know that FICA tax is broken into 2 parts that add up to 7.65%, and we also know this person doesn’t have a big enough salary to reach the $90,000 limit on the Medicare portion of the tax. The 2 portions of FICA tax add up to $201.03, and if you drag out your calculator and multiply the gross pay of $2,692.31 by 7.65%, that is not the amount you’ll get. However, if you take the gross pay and subtract those deductions that belong to the Section 125 Plan, and then multiply by 7.65%, you should come up with the $201.03, give or take fractions of cents due to rounding.
Now we can see that “taxable gross” means different things, depending on the taxes and deductions that are being taken out.
With respect to the FICA tax, taxable gross is equal to  gross pay minus the Section 125 Plan deductions.
With respect to federal and state income tax, taxable gross is equal to gross pay  minus the Section 125 Plan deductions minus 401(k).
In our example, all the voluntary deductions are pre-tax. If there were after-tax (not tax-deferred) deductions, they would be deducted after all the other taxes have been calculated.



The next time you see bewildered-looking people standing in your office doorway with paycheck stubs in their hands, you’ll be able to sit them down and relieve their pain! You can solve the mystery.


Ms. Connors has a bachelor’s in finance from Portland State University in Portland, Ore. She is the sole proprietor of Tigerlily Consulting, her accounting software consulting business. Ms. Connors has been the controller for several companies during her 25-year career. She has also worked as an implementation specialist for 2 accounting software companies. Her client base currently comprises architects, engineers, and other professional service providers. She implements and supports accounting systems that specialize in project management and time and materials billings. She lives in Atlanta and can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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