One of the best parts of being an hourly rather than salaried employee is the opportunity for overtime, but sometimes you work more hours and bring home a smaller paycheck. And then there are the eagerly awaited bonuses that have such an unexpectedly huge chunk of taxes taken out that your plans for the windfall fly right out the window. What happened? (You know, aside from the cursing and throwing things in a fit of pique.)
Before you figure out why the tax rates can change from paycheck to paycheck, we need to look at what’s being taken out in the first place. The numbers below are the rates for 2013.
- Social Security tax = 6.2% of your first $113,700 in income.
- Medicare tax = 1.45% of your income up to $200,000, then an additional 0.9% on wages above that number.
- Federal income tax rates vary based on your marital status – Single, Married filing a joint return vs. separate returns, Widow(er) with a dependent child or children, or Head of Household. For example, let’s look at the rates for someone filing as single (this and other rates are available here).
- 10% on taxable income from $0 to $8,925, plus
- 15% on taxable income over $8,925 to $36,250, plus
- 25% on taxable income over $36,250 to $87,850, plus
- 28% on taxable income over $87,850 to $183,250, plus
- 33% on taxable income over $183,250 to $398,350, plus
- 35% on taxable income over $398,350 to $400,000, plus
- 39.6% on taxable income over $400,000.
- Depending on your location, you may pay other state and local taxes.
As you can see above, the amount of income tax you’re assessed varies as you earn more money during the year. However, it would really suck if your taxes were actually taken out of your check this way. The first few checks from which only 10% were taken out would be fantastic, but then as soon as you earned $8,925 your next check would have an extra 5% removed, and the same thing would happen each time you crossed another threshold. No one wants to earn less and less as the year goes on, so your payroll department (or their accounting software, more likely) will figure out your average rate assuming that each check will be more or less the same amount. This is great until you get a check that’s abnormally high for some reason and the software recalculates your rate as if that check is what you make every time.
As an example, let’s look at a hypothetical single-filer earning $15/hour and working 40 hours a week who’s paid biweekly. For simplicity’s sake, we’ll assume you don’t have any other voluntary withdrawals such as contributions to a health insurance plan and that you don’t pay any state/local taxes (though if you do pay state/local taxes the effect may be exaggerated even more since those percentages may be revised upwards as well). We also won’t worry about any exemptions you have that would lower your rate.
- $15 times 40 hours times 52 weeks in a year equals an expected salary of $31,200. Your top marginal tax rate is 15% and the actual rate is 13.57%. (10% of $8,925 plus 15% of $31,200-$8,925; divided by $31,200)
- Each normal paycheck covers two weeks, or 80 hours, for a pre-tax total of $1,200 (and $1,200 times 26 checks equals $31,200). You’ll pay $74.40 in SS tax, $17.40 in Medicare tax, and $162.84 in federal income tax each pay period and take home a check for $945.36. A total of 21.22% of your pay was paid in taxes.
- Overtime time! For two weeks running you come in on a day off and work a total of 96 hours. Lucky you, you get time-and-a-half for overtime, so we’ll add 16 hours at $22.50 to your usual check! Your pre-tax total on this check is $1,560.
- Unfortunately, the accounting software probably won’t recognize this as a one-time aberration and will recalculate your average tax rate as if all your checks are this amount. $1,560 times 26 checks is $40,560. That bumps part of your presumed salary up into the next tax bracket and your new average yearly income tax rate is 14.96%.
- You’ll now pay $96.72 in SS tax, $22.62 in Medicare tax, and $233.38 in federal income tax, leaving you with a check for $1,207.28. Your pre-tax pay for those two weeks went up by $360, but your actual check only went up by $261.92. (And in real life if you have other taxes or employee contributions taken out, your check can shrink even more.) A total of 22.61% of your income for those two weeks was paid in taxes.
- Good news! You got a $1500 annual bonus from last year added to your first check for this year, giving you a one-time check for $2,700. Bad news! This causes your average yearly rate to calculate as 33.23%, since it looks like you’re on track to make $70,200. After all the taxes are taken out (a total rate of 40.88%), you’re left with $1,596.24. Your check only went up by a lousy $650.88; the other $849.12 of your bonus went straight to Uncle Sam. (And again, if you have to pay any state/local taxes, kiss even more of your “bonus” goodbye.)
The good news is that when you overpay on a paycheck or two, you’ll eventually get that money back in next year’s refund, but that’s small consolation when you’ve actually made plans for the money when you were supposed to get it. If you know ahead of time that you’ll be working significant extra hours or receiving a bonus or vacation pay, ask your payroll department if they can issue a separate check for the extra amount in order to trick the software into calculating the taxes at a lower rate, or ask them if they have any other tricks to make sure you get to keep as much of your paycheck as possible. Hopefully they’ll be sympathetic to your plight!