What is Net Pay?
For many employees, the term net pay is what matters most when it comes to verifying correct pay from an employer. The term net pay refers to how much money each employee deposits into their account once income taxes, deductions, and other benefits are subtracted.
Net pay is visible on most pay stubs, but it also aligns with the amount that most people will receive via direct deposit each pay period.
In this article, we'll discuss the benefits of understanding net pay and provide examples for calculating the appropriate amount per paycheck.
Here’s What We’ll Cover:
How is Net Pay Different Than Gross Pay?
Gross pay and net pay are different in that the former is the amount of money you earn based on the definition of your annual salary, and the latter is how much money you can expect to see in your bank account after payroll taxes are deducted from your compensation.
Why is Net Pay Important?
Net pay is important because all employees should understand how much money they are collecting at each pay cycle.
Net pay is helpful because it allows an employee to:
- Create a practical monthly budget based on actual take-home wages
- Understand payroll deductions, like federal income tax
- Have better visibility into voluntary deductions
From an accounting perspective, net pay is the inflow of cash that can be used for other costs and living expenses.
Considerations for Employers
Employers are responsible for gathering information about each new hire through Form W 4, the Employee's Withholding Certificate. Before an employer can calculate net pay, this form provides information about the number of:
- Tax exemptions a person wants to claim (based on marital status and dependents)
- Jobs that an individual holds at a given time
- Optional tax withholdings or additional deductions per paycheck
In the United States, employers are required to collect and maintain this data, and employees should provide updates about any significant changes.
The information on a W 4 is part of the reason that gross income is different from net pay.
Considerations for Salaried vs. Hourly Employees
Being salaried or hourly does not affect your net pay amount. In general, salaried workers may have access to a few more employee benefits (including employer-sponsored retirement contributions and paid time off), but your calculated net income is not dependent upon your status as salaried or hourly.
How to Calculate Net Pay
Now that we've answered the question, "What is net pay?" we'll illustrate a simple process for calculating it. Once you know your gross income for each pay period, here is how to calculate the amount of net pay.
Step 1: Gross Pay - Pretax Contributions and Deductions = Taxable Wages
Step 2: Taxable Wages - All Payroll Taxes (Income and FICA Taxes) - Voluntary Deductions = Net Pay
Employees have a right to know that the amount of money they earn on each paycheck is accurate. While an employer often includes gross income and net income amounts, this simple math is useful for verification.
Payroll Tax Deductions that Affect Net Pay
Whether you work for a small business or large corporation, you must pay taxes every payroll cycle.
Federal Taxes – Each employee pays federal income tax based on earned wages and tax bracket.
State Income Taxes – State income tax is another line item subtracted from gross pay.
Social Security Contributions – On every paycheck, a deduction is made for Social Security.
Medicare – Payroll contributions to Medicare are required for all employed persons in the United States.
Retirement and Insurance Contributions
An employee can choose from several helpful deductions each pay period to cover investments and other provisions for themselves or their families. Employee contributions include:
Health Insurance Premiums - While an employer might contribute to a portion of a plan, health insurance costs are one of the most popular employee deductions.
Health Savings Account – Employees and businesses can contribute to HSAs, which are governed by a strict set of rules and requirements.
Life Insurance – A small portion of wages may go to an employer-sponsored life insurance program.
Retirement Investments – In terms of saving for later in life, most employees contribute part of their paycheck to a retirement fund, such as a 401(k) or 403(b).
Does Net Pay Matter for Tax Returns?
No, not necessarily. Gross income is taxable income, meaning that gross pay (not net pay) is the amount of money that your tax returns are based on.
Your net pay amount, however, does indicate whether you have paid enough income taxes throughout the year. If you have not paid enough federal income tax based on your tax rate, you may owe the IRS at filing time.
More Accounting Resources for Small Businesses
- How to Calculate Payroll Taxes: Taxes and Percentages
- What is FICA Tax? Understanding Payroll Tax Requirements