Taxes, Net Income, and Budgeting

Five kinds of tax

Individuals pay taxes to federal, state and local governments. You will run into five kinds: income taxes, capital gains taxes, payroll taxes, property taxes and sales taxes.

Which ones you pay, and how much, depends partly on where you live, because the types and amounts of taxes vary by state. A few states have no state income tax at all, and sales tax rates differ from one state to the next.

Withholding, returns and refunds

Income taxes are the percentage of income that individuals pay to the government. If you work for an employer, a portion of each paycheck is withheld and paid to the government directly by your employer.

Withholding is a running estimate. Once a year, you or your household file an income tax return that works out what you actually owed. If too little was withheld, you pay the remainder. If too much was withheld, the overpayment comes back to you as a refund. Say $4,100 was withheld over the year and your return shows you owed $3,650. You get $450 back. That refund was always your money; your employer just withheld more than you owed.

Self-employed people, such as a freelance photographer or a plumber with her own business, have no employer withholding for them. They are responsible for submitting their income taxes to the government themselves.

Payroll and capital gains taxes

Payroll taxes are withheld from paychecks too, but they are separate from income tax. They fund specific government insurance programs. The two federal payroll taxes withheld from most U.S. paychecks are Social Security and Medicare, and the employer pays a matching amount on top, so the employer is responsible for half of these taxes. Self-employed people and contract workers have no employer to split them with, so they pay the full amount themselves. Unemployment benefits are funded by payroll taxes too, but in most states employers pay those entirely. Medicaid, which is sometimes listed with these programs, is paid for by federal and state governments out of general revenue, not by a payroll tax. Some states also withhold payroll taxes of their own, for programs such as disability insurance or paid family leave.

A capital gain happens when you sell an asset, such as shares of stock, for more than you paid for it. Capital gains taxes are submitted with your income tax return. If you owned the asset for more than a year, the gain is usually taxed at a lower rate than your other income. If you owned it for a year or less, the gain is taxed just like the rest of your income.

Property taxes and sales taxes involve no withholding at all. A property tax bill goes to the owner of the house, land or car. A sales tax is paid by you but collected by the store at checkout, and the store submits it to the government.

Why two households owe different amounts

Two families on the same street can owe very different amounts of federal income tax. The amount depends on the household's income level and on the tax deductions and tax credits it qualifies for.

Income level. The U.S. federal income tax is progressive, meaning that individuals and households earning higher incomes pay higher tax rates. With the same deductions and credits, a household earning more pays more dollars of tax and a larger share of its income. Some state income taxes are progressive too.

Tax deductions reduce taxable income, the income the tax is figured on, and that lowers the tax owed. Deductions may include interest on a home mortgage, contributions to retirement accounts, the value of charitable donations, the amount paid in state and local taxes, and some medical expenses.

Tax credits directly reduce the amount of tax owed. Credits may include a child tax credit, a child or dependent care tax credit, an education tax credit, or credits for specific purchases.

That difference makes a $1,000 credit worth more than a deduction of the same size. If the deducted dollars would have been taxed at 12%, the deduction lowers the tax bill by $120. The credit lowers it by the full $1,000.

Reading a pay stub

Each paycheck comes with a pay stub that shows how the check was figured. It lists gross income, the deductions taken out of it, and net income.

Gross income, or gross pay, is the total you earned during the pay period. It is set by an annual salary divided into pay periods, by the hours you worked during the period, by a specific contracted amount, or by another compensation scheme, such as commission.

Mandatory deductions are required by federal, state or local law, and your employer must withhold them. They typically include income taxes and payroll taxes. Voluntary deductions are amounts you have chosen to have taken out. Most go to employer-sponsored benefits: health insurance, health or dependent care savings plans, life insurance plans and retirement savings. Union dues, if you belong to a union, are a voluntary deduction too.

Some deductions are pretax deductions. The income that goes to them is not included in your taxable income, so they reduce your tax liability, the amount of tax you owe. That makes them an incentive to save: putting money toward retirement through a pretax deduction lowers your take-home pay by less than the amount you save.

Net income, or net pay, is what is left after all deductions are removed. It is the amount of your paycheck, and it can be far smaller than gross income.

Net pay is the number to budget with

A budget plans your spending and saving from the income you expect, and the income that counts is net pay: what is left after taxes and other deductions. Marisol earns $4,875 a month on paper (58,500 divided by 12). What actually reaches her account averages about $3,545 a month (1,636.33 times 26 paychecks, divided by 12). A budget built on the bigger number would plan to spend more than $1,300 a month that never arrives.