Chapter 3: Money at Work
Sgt. Sean Dignam: “I'm the guy who does his job. You must be the other guy."
– The Departed (2006)
It’s good and well—and important—to theorize about human capital. But the rubber hits the road when we go out and get a job. Work is how most of us get our money. It’s how we turn earnings potential into actual income.
Anatomy of a Paycheck
Money from work will come in one of two basic forms: wages from an employer or income as a self-employed person (e.g., as an independent contractor, sole proprietor of a business, or consultant). Here is what a typical pay statement from an employer might look like:
Let’s go line by line. If you have a pay statement, take it out and compare. You may not have all these items, or you may have some others.
Gross pay is pretty straightforward. If your salary is $60,000 a year and you get paid twice a month your gross pay will be, as in this example, $2,500. Then there are a number of deductions:
Before anything else, your employer withholds Social Security tax (part of what’s known as FICA taxes). This tax is actually 12.4% of gross pay, of which the employer pays half and you pay the other half. This tax pays for the Social Security benefits of people who are retired today. It does not get tucked away in some “trust fund” for you, which is a common misconception. Your benefits will be paid for by people who are working when you are retired. Social Security is what’s known as a “pay-as-you-go” pension system.
The next item, Medicare tax (the other part of FICA) is 2.9% of gross pay and works the same way, except it pays for Medicare benefits. Medicare is health insurance provided by the government to anyone over the age of sixty-five. Again, you pay half and your employer pays half. By the way, don’t confuse Medicare with Medicaid, which is medical insurance provided by your state if you’re poor.
Next are income taxes that your employer withholds and pays to the government. Unlike Social Security and Medicare taxes which are deducted at a set rate, the income taxes withheld are an estimate. This estimate is based on the Form W-4 that you fill out. When you file your tax return (by April 15 of the following year), the tax withheld during the year is either more or less than you owe. You either get a refund or pay the difference. State taxes (and in some places local/city taxes) work the same way.
Income taxes are calculated using your taxable wages, which is your gross income minus the pre-tax deductions we’ll discuss next. So more pre-tax deductions mean lower taxes.
If you get health insurance through work you will likely have a deduction for the insurance premiums. Many employers pick up a significant chunk of this cost. Your pay statement only shows the part that you pay.
Another benefit that some employers offer is the opportunity to put some “pre-tax” money into a Health Savings Account (HSA) or a Flexible Spending Account (FSA). We'll cover these accounts in later chapters.
If your employer offers a defined contribution retirement plan—such as a 401(k) or 403(b) plan—you can put money into the plan and invest it for retirement. This is a great opportunity because the money can grow and no taxes are due until you withdraw it many years later. It’s an even greater opportunity if your employer matches your contribution. For example, a plan could specify that the employer contributes 0.5% for every 1% of your pay you contribute, up to 6%. In that example, you receive 3% extra compensation, without having to pay taxes on it until years down the road. You end up with 9% of your pay stashed away for retirement.
You may also have some after-tax deductions. These could be for a variety of benefits. I’ve given two examples in the table.
Some retirement plans offer a “Roth” option (named after a former U.S. Senator from Delaware). As with the regular 401(k) contribution, you specify how much you want contributed to a Roth account. While you contribute money that you have already paid taxes on, the beauty of a Roth contribution is that you get to invest the money and never pay any tax when you ultimately withdraw it.
Another example of an after-tax deduction is long-term disability insurance (LTD). This is insurance that pays you if you cannot work. It is often a voluntary benefit; if it is offered, I strongly recommend you get it. Some employers give you the option of having the premium withheld after tax. Do this. Typically it is not a lot of money and the benefit will be tax-free should you become disabled. Be aware that this insurance may not go with you if you switch jobs.
After all the deductions are taken out of your gross pay, you are left with the net pay you take home.
Self-Employment
We live in the gig economy, so many folks are self-employed. For independent contractors, business owners, consultants, and the like, keeping track of money is more complicated. If you make more than $400 in a year, you owe taxes. Nobody will be withholding them from your pay, so you need make quarterly tax payments to the Internal Revenue Service (IRS) and maybe your state tax department. You’re effectively running a business, which means you’ll need to keep a record of money coming in and expenses going out. With receipts to prove it.
You will also have to cover some of the costs that an employer would otherwise pick up. That means paying the entire 15.3% of FICA taxes on your income (both the employer and employee shares). It means paying 100% of your health insurance premiums. And it means that you need to figure out your own retirement plan. On the plus side, you get a tax break on many of these expenses, so it’s not quite as severe as it sounds.
If you get paid in cash you’re still required to report the income and pay taxes on it. What if you don’t? Well for one, you are breaking the law. Further, when you work “under the table” for too long, you get dinged when it comes to receiving Social Security and Medicare, both of which require that you pay FICA taxes for at least ten years.
None of this is meant to discourage anyone from being their own boss. Just be aware that the financial responsibilities that come with being self-employed are greater than when working for an employer.
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