Net Pay

Net pay is the money an employee actually receives after gross pay has been reduced by taxes and all other deductions. Starting from gross pay, an employer subtracts income tax withholding, the Social Security and Medicare taxes, and any elected deductions such as retirement contributions, health and other insurance premiums, and garnishments. What remains is net pay, the figure a household treats as its income for budgeting. It is commonly called take-home pay.

The order in which deductions come out matters, because it determines which taxes each one avoids. Pre-tax deductions are subtracted from gross pay before a tax is calculated, so they lower that tax. Post-tax deductions come out of pay that has already been taxed. A traditional 401(k) contribution is pre-tax for income tax but not for Social Security and Medicare tax, so it reduces income tax withholding while still being fully subject to the 6.2% and 1.45% payroll taxes. A health premium paid through a Section 125 cafeteria plan is pre-tax for both, so it escapes income tax and payroll tax alike. A Roth 401(k) contribution and union dues are post-tax, so they reduce net pay dollar for dollar without changing any tax.

Net pay is also a systematically low measure of what an employee is worth to an employer. It leaves out the employer's matching 6.2% Social Security and 1.45% Medicare tax, employer 401(k) contributions, the employer's share of health premiums, and other benefits. Two offers with the same net pay can differ substantially in total compensation once those are counted, which is why net pay is the right number for a household budget but the wrong number for comparing job offers. The line-by-line document that shows how gross pay became net pay is the pay stub.

Net pay is computed by walking down from gross pay through each deduction.

A hypothetical example. Marcus is paid a $5,000 monthly gross salary. Each month he contributes $300 to a traditional 401(k) and pays a $200 health premium through his employer's Section 125 plan, and he has $25 of post-tax union dues.

• Wages subject to income tax: $5,000 minus the $300 401(k) and the $200 health premium equals $4,500. His federal income tax withholding on that is, say, $450, and his state withholding $150 (both illustrative).

• Wages subject to Social Security and Medicare tax: $5,000 minus only the $200 health premium equals $4,800, because the 401(k) is not exempt from those taxes. At the combined 7.65% rate, that is $367.20.

• Net pay: $5,000 minus $300 (401(k)) minus $200 (health) minus $367.20 (Social Security and Medicare) minus $450 (federal) minus $150 (state) minus $25 (dues), which equals $3,507.80.

That $3,507.80 is what lands in his account. Note the 401(k) reduced his net pay by $300 but his taxes by less than if it had been fully pre-tax, because it did not escape the payroll taxes.

Pros of budgeting on net pay

• It is the real number: net pay is the cash a household actually controls each period.
• It automatically reflects taxes and required deductions, so a budget built on it will not overstate what is available.

Cons and cautions

• Net pay understates total compensation, so comparing two job offers on take-home pay alone ignores employer benefits, retirement matches, and the employer's share of payroll tax.
• Increasing a pre-tax deduction lowers net pay by less than its full amount, which is easy to miscount when deciding how much to contribute.
• Net pay can swing between checks as bonuses, overtime, or benefit changes move gross pay and the deductions that scale with it.