But when that first new paycheck rolls around, you might be disappointed. The large amount you were expecting is nowhere to be seen; rather, the increase in take-home pay is much smaller than you thought it would be. Below, we explain how to understand your paycheck, work out where your earnings are going, and how you can improve your take-home pay.
Where Did Your Raise Go?
To understand how a raise in your gross salary or hourly rate will affect the money you actually take home, you need to understand how taxes and other deductions are calculated. Let’s start with the difference between the terms “gross” and “take-home” earnings. Your gross pay is the amount of money your employer has actually paid. Various deductions (including taxes) then are taken out of this amount, and the details are recorded on your paycheck. After all the deductions have been taken, the amount left is your take-home pay. The majority of taxes and other deductions are calculated as a percentage of your gross pay. For example, the 2022 tax rate for Medicare tax is 1.45% for the employee—so if you earn $1,000, you’ll pay $14.50 in Medicare tax. Because of this, the amount of money you pay in tax increases with your increased pay. That said, almost all of your raise can be swallowed up by taxes and other deductions. Let’s look at these deductions in more detail.
Taxes
It’s likely that the biggest single deduction from your paycheck is taxes—both federal and state—and you may find that almost all of your raise is taken back via these taxes. It can be very complicated to work out how much income tax you should be paying, even for tax experts, and getting a raise can have particularly confusing tax implications. For example, many people fear that receiving a raise will catapult them into a higher tax bracket, and they’ll wind up worse off than they were before. This, however, is a somewhat misguided notion about how the progressive federal income tax system works in the U.S. While those who receive salary increases are indeed taxed at higher rates, only the added income is vulnerable to the increased rates. In other words, you’ll pay your new marginal tax rate on the extra money you’re earning, not your whole paycheck. On the other hand, it’s likely your marginal tax rate—the amount you pay on your raise—is much higher than your effective tax rate. This means, for example, that you might pay just 20% of your overall income in tax, but that your raise is taxed at more than 30%.
Retirement
Contributions to your retirement account might also reduce the proportion of your raise you get to take home. This is because just as with taxes, your retirement contributions may well be calculated as a percentage of your gross pay. This means that as your pay increases, your retirement contributions will also increase. For example, let’s say you contribute 10% per year to your 401(k). If your salary increases from $80,000 to $90,000, your contribution will increase from $8,000 per year to $9,000 per year. This will impact your paychecks. If you have an employer-sponsored retirement account such as a 401(k), this may be a blessing in disguise. Contributions to your retirement account are tax-free, as long as you stay below the annual limit. It may be frustrating to not see the raise in your paycheck, but you will be glad your contribution also went up when it’s time to retire later in life. Experts say you should contribute at least the percentage that your employer matches to your 401(k), and max out potential contributions to an IRA, but you could also contribute more once you get a raise. This is the ideal time to increase your retirement contributions because you will likely not even miss the money. Just keep in mind the contribution limits for both 401(k)s and IRAs.
Health Care
Health care costs are another factor that can take a chunk out of your raise. In part, this is because many health care related taxes and deductions are also calculated as a percentage of your gross pay. As mentioned earlier, the Medicare tax rate for employees is 1.45%. Health care costs can be more complex than this, though, because many federal and state health care programs are designed to lower the cost of health care for people on lower incomes. The cost of your health insurance, for example, might depend on you earning below a defined maximum salary. Similarly, getting a raise might reduce or even eliminate your access to certain health care benefits and premium tax credits.
Other Benefits
In addition to the above factors, there may be other deductions coming out of your paycheck. These can include stock purchase plans, commuter programs, or life insurance. If the cost of these is calculated as a percentage of your gross income, you’ll also see your contributions rise in line with your raise.
Check Your Pay Stub
If you think that your post-raise take-home pay is incorrect, you can check your pay stub—it should outline all of the taxes and deductions that apply to your situation. First, find a pre-raise pay stub, ideally the last one before you got your raise. Then, find your first post-raise pay stub where you earned your new salary for the entire pay period. After that, follow these steps: If you don’t think you were given the raise you were supposed to get, first contact your HR or payroll department. Some companies use strange abbreviations for deductions, or simply produce confusing pay stubs. They’ll be able to help you understand your paycheck. If you did receive the raise you were expecting, and are not happy with the take-home pay, consider changing your contributions to retirement or other optional programs. You can also update your withholding on your W-4.
