Gross, Net, and Taxable Income; W-2 and 1099
Aiden gets his first paycheck from a grocery store. He worked all month, but the amount deposited is smaller than he expected. Where did the rest go, and who decided how much to take? By the end of this page you will be able to trace every dollar from the top of a pay stub to the bottom.
Gross, taxable, and net income
Three different numbers describe your income, and they are easy to mix up.
Why do we need three numbers? Because they answer three different questions: how much did I earn, how much gets taxed, and how much can I spend.
Here is the key idea: deductions lower your taxable income, so you pay income tax on less than you earned. The standard deduction is a set amount that almost every filer can subtract.
Match each term with its description: gross income net income (take-home pay) taxable income Descriptions: (a) the amount on which income tax is actually calculated,…
Match each term with its description:
-
gross income
-
net income (take-home pay)
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taxable income
Descriptions:
(a) the amount on which income tax is actually calculated, after deductions;
(b) total pay before anything is taken out;
(c) the amount you receive after taxes and other deductions.
Aiden's paycheck shows gross pay of $\$1{,}200$. Total deductions for taxes and health insurance are $\$270$. Calculate his net pay. What percent of his gross pay was…
Aiden's paycheck shows gross pay of $\$1{,}200$. Total deductions for taxes and health insurance are $\$270$. Calculate his net pay. What percent of his gross pay was deducted?
Progressive brackets and the standard deduction
The US federal income tax is progressive: higher slices of income are taxed at higher rates. A rate applies only to the slice inside its bracket, not to all of your income.
Notice that the marginal rate (the rate on her last dollar) is 12%, but her effective rate is about 7%. The effective rate is lower because of the deduction and the cheaper first bracket.
Camila's gross wages for the year are $\$38{,}000$. Assume a standard deduction of $\$14{,}000$. Use these simplified brackets: 10% on the first $\$11{,}000…
Camila's gross wages for the year are $\$38{,}000$. Assume a standard deduction of $\$14{,}000$. Use these simplified brackets: 10% on the first $\$11{,}000$ of taxable income and 12% on the rest.
(a) Calculate her taxable income.
(b) Calculate her income tax.
(c) Explain why her taxable income is lower than her gross income.
Taxes on income vs. taxes on spending
Taxes can hit you at two moments: when you earn and when you spend.
| Tax on income | Tax on spending | |
|---|---|---|
| Examples | Federal income tax, FICA | Sales tax |
| When you pay | Taken out of your paycheck | Added at the register |
| Base | Pay you earn | Price of what you buy |
| Rate | Often progressive (income tax) | Usually a flat percent |
FICA is the payroll tax that funds Social Security and Medicare. An employee pays $7.65\%$ of gross pay (the employer pays another $7.65\%$).
A tax on spending is paid only when you buy something taxable. A tax on income is paid on what you earn, whether or not you spend it.
Lena spends $\$500$ on a tablet with an 8% sales tax. Separately, she earns $\$500$ at her job, which is subject to 7.65% FICA and 12% federal income tax. (a) Calculate…
Lena spends $\$500$ on a tablet with an 8% sales tax. Separately, she earns $\$500$ at her job, which is subject to 7.65% FICA and 12% federal income tax.
(a) Calculate the sales tax on the tablet.
(b) Calculate the FICA and income tax on the $\$500$ of earnings.
(c) Compare the two and explain how a tax on spending differs from a tax on income.
W-2 employees and 1099 contractors
Who you work for as a worker determines the tax form you receive in January.
A restaurant server hired as an employee gets a W-2, and the employer withholds income tax and FICA. A freelance photographer paid $\$3{,}000$ for a project gets a 1099-NEC. The client withholds nothing, so the photographer must set money aside.
Contractors pay self-employment tax of $15.3\%$. That is $7.65\%$ for the employee half of FICA plus $7.65\%$ for the employer half, because the contractor has no employer.
The contractor pays $\$459$ more because he covers both halves of FICA. He is also responsible for paying the tax himself, usually through estimated quarterly payments, and for filing it on his tax return.
Say whether each worker would normally receive a W-2 or a 1099-NEC, and who withholds taxes: (a) a restaurant server hired as an employee; (b) a freelance photographer…
Say whether each worker would normally receive a W-2 or a 1099-NEC, and who withholds taxes:
(a) a restaurant server hired as an employee;
(b) a freelance photographer paid $\$3{,}000$ by a client for a project.
Ethan earned $\$6{,}000…
Ethan earned $\$6{,}000$ doing a summer project. Assume his income tax rate is 12% of this amount (ignore deductions).
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Case 1: he was a W-2 employee and paid 7.65% FICA.
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Case 2: he was an independent contractor with a 1099-NEC and paid self-employment tax of 15.3%.
(a) Calculate his total tax in each case.
(b) Calculate the difference.
(c) Explain why a contractor's tax bill is bigger and what responsibility he has for paying it.
Putting it all together
Real paychecks mix several of these ideas. Some deductions, like a traditional 401(k) contribution or a health insurance premium, come out before income tax, so they lower taxable income.
Without the 401(k), take-home rises by only $\$110$, not the full $\$125$, because the contribution reduced his income tax by $\$15$. Stopping may feel good now, but that $\$125$ is savings that grows for retirement, and it is often matched by an employer. Giving that up is usually a poor trade.
Sofia has these income items for the year: W-2 wages of $\$32{,}000$, from which $\$2{,}000$ of federal income tax was withheld; $\$4{,}000…
Sofia has these income items for the year:
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W-2 wages of
$\$32{,}000$, from which$\$2{,}000$of federal income tax was withheld; -
$\$4{,}000$from freelance work (Form 1099-NEC); -
$\$200$of bank interest (Form 1099-INT).
Assume a standard deduction of $\$14{,}000$ and these simplified brackets: 10% on the first $\$11{,}000$ of taxable income and 12% on the rest. Self-employment tax is 15.3% of the freelance income. Ignore any other deductions.
(a) Calculate her gross income and her taxable income.
(b) Calculate her income tax and her self-employment tax.
(c) Calculate how much she still owes or is refunded after the withholding.
(d) Explain which forms report each item.
Noah earns $\$2{,}500$ gross per month. Each month he puts 5% of gross into a traditional 401(k) and pays a $\$150$ health premium, both taken out before income tax.…
Noah earns $\$2{,}500$ gross per month. Each month he puts 5% of gross into a traditional 401(k) and pays a $\$150$ health premium, both taken out before income tax. Income tax is 12% of the income that remains after these two amounts. FICA of 7.65% is calculated on the full $\$2{,}500$.
(a) Calculate his taxable income for the month, income tax, FICA, and net pay.
(b) Recalculate his net pay if he stops contributing to the 401(k).
(c) Argue whether his take-home pay really falls by the full 401(k) contribution, and whether stopping is a good idea.
Back to the start: Aiden's paycheck is smaller because gross pay is reduced by income tax, FICA, and insurance, leaving net pay.