How Money Flows: Income, Paychecks & Taxes

Overview

Your first real paycheck — and realizing quickly that the amount deposited is not the amount you thought you earned. This chapter explains the mechanics behind income, taxes, withholding, and pay stubs so you always know where your money is going and why.

By the end of this chapter, you will be able to:

  • Read any U.S. paycheck and understand every line.
  • Know exactly why your paycheck is smaller than your wage × hours.
  • Understand gross income, net income, and taxable income.
  • Calculate approximate take-home pay from a job offer.
  • Understand how federal income tax, FICA, and state tax work.
  • Adjust your withholding properly using a W-4.

Everything is explained using real numbers.

1. Gross Income vs Net Income

1.1 Gross Income

Gross income is the total amount you earn before any deductions.

Examples:

  • Hourly worker:
    30 hours × $16/hr = $480 gross
  • Salaried worker:
    $52,000 per year = $2,000 gross per biweekly paycheck

Gross income is not what you receive.

1.2 Net Income (Take-Home Pay)

Net income is what lands in your bank account after taxes and deductions.

Net income = Gross Income − Taxes − Deductions

For many new workers, this is the biggest shock:
Your net pay is usually 20–35% lower than your gross pay.

2. Understanding Taxes That Reduce Your Paycheck

Every U.S. paycheck has three main categories of taxes:

  1. Federal income tax
  2. FICA taxes (Social Security and Medicare)
  3. State income tax (unless you live in a no-tax state)

Below is what each one actually does and how much it takes.

3. Federal Income Tax

Federal income tax is based on IRS tax brackets.

3.1 Tax Brackets Are Marginal

This means different chunks of your income are taxed at different rates.

Example (simplified, single filer):

Income Range Tax Rate
$0–11,600 10%
$11,600–47,150 12%
Higher amounts higher rates

If you earn $40,000:

  • First $11,600 taxed at 10%
  • Remaining $28,400 taxed at 12%

Your effective tax rate is much lower than your bracket rate.

3.2 How Much Comes Out Per Paycheck?

Your employer uses your W-4 form to estimate how much tax to withhold each pay period.

If withholding is too high → big refund
If withholding is too low → you owe taxes in April

Example:

  • Biweekly gross: $2,000
  • Federal tax withheld: ~$180–$260 depending on your W-4

You won’t see the bracket math on your pay stub — just the withheld amount.

4. FICA Taxes (Social Security & Medicare)

These taxes are flat rates, not brackets.

Social Security (6.2%)

6.2% of gross income, up to the annual wage cap.

Medicare (1.45%)

1.45% of gross income, no cap.

So FICA = 7.65% of every paycheck for most workers.

Example:

  • Gross pay: $1,000
  • 7.65% × $1,000 = $76.50 FICA withheld

FICA is unavoidable and separate from income tax.

5. State Income Taxes

Approximately 42 states charge income tax.

Rates vary:

  • Flat tax states (e.g., Colorado: a single rate)
  • Bracketed states (e.g., California: multiple tiers)
  • No income tax (e.g., Texas, Florida)

Example for a $1,000 paycheck:

  • High-tax state: $40–$70 withheld
  • Low-tax state: $15–$30 withheld
  • No-tax state: $0 withheld

6. Other Paycheck Deductions

In addition to taxes, your pay stub may include:

6.1 Pre-Tax Deductions

These lower your taxable income:

  • 401(k) contributions
  • Health insurance premiums
  • HSA contributions
  • FSA contributions

Example:
Gross pay: $2,000
401(k) contribution: $200
Taxable income becomes $1,800, not $2,000.

6.2 Post-Tax Deductions

These come out after taxes:

  • Roth 401(k)
  • Union dues
  • Certain insurance premiums

These do not lower taxable income.

7. How to Read a Pay Stub (Line by Line)

Here is a simplified example for a biweekly worker:

Gross Pay: $2,000

  • Federal Income Tax: $220
  • Social Security: $124
  • Medicare: $29
  • State Income Tax: $43
  • 401(k) Pre-Tax: $100

Net Pay: $1,484

Below is how each line is determined.

7.1 Gross Pay Calculation

If hourly:
40 hours × $25/hr = $1,000 per week.
Biweekly = $2,000 gross.

7.2 Federal Withholding

Based on IRS formula + W-4 selections.

Estimating manually:

  • Effective tax rate ~10–13% for lower incomes
  • So $2,000 × 11% ≈ $220 withheld

7.3 Social Security

$2,000 × 6.2% = $124

7.4 Medicare

$2,000 × 1.45% = $29

7.5 State Income Tax

Assume 2.15% flat:
$2,000 × 2.15% = $43

7.6 Pre-Tax 401(k)

Employee chooses contribution amount:
$100

7.7 Net Pay

$2,000 − $220 − $124 − $29 − $43 − $100 = $1,484

This is the amount deposited.

8. Understanding Withholding vs Actual Tax Owed

Many people misunderstand this:

  • Withholding is a guess
  • Actual tax is calculated at the end of the year

If Withholding > Actual Tax

→ You get a refund.

If Withholding < Actual Tax

→ You owe.

Example:

  • Total federal tax withheld: $3,900 across the year
  • Actual federal tax owed: $3,600
    → $300 refund.

This distinction matters for planning.

9. How to Estimate Your Take-Home Pay From a Job Offer

Use this method:

Step 1 — Start With Gross Annual Salary

Example: $40,000 salary

Step 2 — Convert to Pay Period

Biweekly: $40,000 / 26 = $1,538 gross

Step 3 — Subtract FICA

7.65% × $1,538 ≈ $118

Step 4 — Estimate Federal Tax

Use a conservative estimate:
10–13% for this income level
Say 12% × $1,538 ≈ $185

Step 5 — Add State Tax

Varies:

  • No-tax state: $0
  • Low-tax state: ~$25
  • High-tax state: ~$60

Assume $25.

Step 6 — Consider Pre-Tax Deductions

If contributing 5% to 401(k):
5% × $1,538 = $77

Step 7 — Net Pay Estimate

$1,538
− 118 (FICA)
− 185 (federal)
− 25 (state)
− 77 (401(k))
= $1,133 take-home

This is the real paycheck.

10. W-4: Controlling Your Withholding

The W-4 is how you tell your employer how much tax to withhold.

Key sections:

10.1 Step 2 — Multiple Jobs

If you have more than one job, total tax owed increases.
Checking this ensures proper withholding.

10.2 Step 3 — Dependents

If you have none, this stays blank.

10.3 Step 4 — Optional Adjustments

  • 4(a): Extra income
  • 4(b): Deductions
  • 4(c): Extra withholding per paycheck

For most young workers, leaving 4(a) and 4(b) blank and using 4(c) only when needed is safest.

11. Common First-Job Payroll Mistakes to Avoid

Mistake 1 — Thinking paycheck = wage × hours

It never does. Taxes reduce it.

Mistake 2 — Ignoring the W-4

Bad setup = refund shock or tax bill.

Mistake 3 — Not checking withholding after a raise

Higher income may require adjusting the W-4.

Mistake 4 — Confusing 401(k) Roth vs Traditional

Only Traditional lowers taxable income.

Mistake 5 — Overdrafting from timing issues

Deposits and withdrawals may not settle the same day.

Key Takeaways

  • Gross income and net income are very different.
  • Every paycheck subtracts federal tax, FICA, and possibly state tax.
  • FICA alone removes 7.65% from every paycheck.
  • Pre-tax deductions lower taxable income and increase take-home pay.
  • W-4 controls how much tax is withheld.
  • A proper take-home estimate lets you plan your real-world budget.