What many of us have accepted as a fact of working is shockingly frustrating to young people just starting out. My children refer to this irritating transition as “adulting,” the period where you are expected to move from childhood to adulthood, which includes taking control of your financial life.
There is so much to learn when you begin paying your own bills, starting with what’s taken out of your paycheck. With this in mind, I’ve decided to devote my column occasionally to Financial Adulting 101, focusing on money basics.
I will keep the adulting columns as simple as possible because experience with my own three has shown me that imparting too much information at one time can prompt them to tune out. After explaining FICA to my children, for example, I attempted to talk about other sections of their pay stub, and they were like, “I’m out.”
So, let’s begin with a paycheck primer.
“It’s important to know where your funds are going and why you are paying them,” said Eric Bronnenkant, head of tax at Betterment, a digital investment advisory firm. “Most people just kind of lump all taxes into one bucket.”
On your pay slip, you will find a section related to FICA, or the Federal Insurance Contributions Act, which funds the Social Security and Medicare programs.
Or those funds might be listed as separate payroll taxes. One is for Social Security’s Old-Age, Survivors, and Disability Insurance (OASDI), which benefits seniors, workers who develop disabilities and families in which a spouse or parent dies. The other is for Medicare, which provides health care for Americans 65 and older.
When you start a new job, you are asked to fill out a W-4 form, also known as the IRS’s Employee’s Withholding Certificate, which allows your employer to withhold federal income tax from your pay. If too little is withheld, you will generally owe the government money when you file your tax return and may owe a penalty. If too much tax is withheld, you will generally be due a refund.
In 2020, the W-4 was updated to simplify the form to reflect tax code changes under the 2017 Tax Cuts and Jobs Act. The form has five steps, starting with entering your personal information and filing status and ending with you signing the form. Steps 2 through 4 need to be filled out if you have multiple jobs, plan to claim tax credits for dependents or have other adjustments for additional income.
Here’s a breakdown of the taxes being withheld:
OASDI: The federal Old Age, Survivors and Disability Insurance program, otherwise known as the Social Security tax. It will take 6.2 percent of the first $160,200 of your wages for 2023. So an individual earning that much this year would contribute $9,932.40 to OASDI. The person’s employer would contribute the same amount. If you’re self-employed, you pay the full 12.4 percent OASDI tax rate, though you also get a deduction for half of what you pay, according to IRS spokesman Eric Smith.
Medicare: This represents 1.45 percent of your taxable wages, with an additional 0.9 percent tax applying to some high-earners. Unlike the OASDI tax, there is no limit on the amount of income subject to Medicare taxes. The self-employed are also responsible for paying the full Medicare tax, half of which is also deductible. Medicare is also available for some people younger than 65 with disabilities or end-stage renal disease.
Federal withholding: The amount of income tax withheld that goes to the federal government. It is based on how much you earn and the information you give your employer on your W-4.
State withholding: Any state and/or local taxes withheld from your pay. Some states, such as Florida, don’t collect personal income taxes.
Here are some paycheck terms you should know.
Total gross: The running tally of what you have earned for the current pay period or YTD (year to date) before any withholdings or deductions.
Employer-paid benefits: Benefits paid for by your employer, such as matching contributions to a retirement savings plan like a 401 (k).
Pretax deductions: Any money exempt from income taxes, including medical or dental insurance, or money you elected to put into a flexible spending account or workplace retirement plan. Pretax deductions reduce your taxable income and, thus, the amount of money owed to the government.
Post-tax deductions: Deductions that are not exempt from income taxes and FICA. These include life insurance, long-term disability insurance, union dues or charitable contributions taken out of your paycheck.
Net pay: The earnings you ultimately get to take home after all taxes and deductions.
You may complain about paying into the Social Security system because you’ve heard it may not be around long enough for you to claim benefits.
This is a big financial problem. The reserves for the Old-Age and Survivors Insurance (OASI) Trust Fund, which pays retirement and survivors benefits, is projected to have a shortfall and won’t be able to pay full benefits in 2034, according to the most recent trustee report for the Social Security and Medicare trust funds. At that point, only 77 percent of the benefits will be payable.
Worse case, benefits are cut or taxes are raised, but Social Security is too vital to too many Americans to be eliminated. In 2022, 55 percent of seniors reported that Social Security was a major source of their income, according to Gallup.
When my nephew received his first paycheck decades ago, he complained about FICA, exclaiming, “I’ve been robbed.”
“No, Tom,” I countered. “You’ve been taxed.”
Bronnenkant describes FICA as “a retirement program designed to reduce the risk of poverty in your old age.”
You might not like FICA, but your older self will appreciate the income.