We recently got a question from a client. Their first paycheck of the year had dropped by a few hundred dollars versus the previous one. They asked us for some insight. Since they are long-time clients and we know their situation pretty well, we answered the question quickly and accurately without even needing to ask for the last couple of paystubs. We thought the experience would serve as a quick lesson on a couple of payroll deductions. So what are a couple of common reasons that a person’s take-home pay can drop several hundred dollars at the start of the new year?
Retirement Plan Contributions
There are several different types of retirement plans. Every single one has a maximum amount that an employee can contribute to the plan and employers must follow the rules. The limits are for the contributions an employee makes over the course of a calendar year and they reset every year on January 1. These limits are only for the employee’s contributions; employer matching and profit-sharing contributions are considered separately.
In 2021, an employee could contribute up to $19,500 to a qualified retirement plan like a 401(k), 403(b), 457(f), or the TSP. The 2022 maximum increases to $20,500. In addition, there’s something called a “catch-up” contribution you can make if you’re age 50 or older. That’s another $6,500 on top of the $20,500.
Most retirement plans ask the employee to select a percentage of their salary that they want to contribute to the retirement plan. So if a person’s salary is $100,000, and they’ve chosen to contribute 10%, the total employee contributions for the year will be $10,000. Since that isn’t close to the annual limit, the deduction will be the same for every paycheck.
High-level managers and executives are often compensated through a combination of base salary and performance bonuses. The bonuses are usually paid once a year. Likewise, most employers apply the retirement plan contribution rate to all payments – base and bonus. As a result, many executives hit the annual retirement plan contribution limit when their bonus is paid.
For example, a person with an annual salary of $200,000 that is paid bi-weekly has a gross paycheck of $7,692. If they are contributing 10% to their retirement plan, $769 is contributed every pay. Using only their base, their contributions will add up to $19,994 over the course of the year and the contribution will be the same every pay. But what if they receive a bonus in July for $75,000?
For the first half of the year, they contributed $9,997 to the retirement plan. Then, 10% is deducted from their bonus for the retirement plan. That $7,500 plus the $9,997 that they already contributed puts them close to the limit. They’ve contributed $17,497. There’s $3,003 before they hit the $20,500 contribution limit. At $769 per pay, they’ll hit that maximum in the fourth paycheck after the bonus was paid. Payroll will automatically cut off contributions when they hit $20,500.
After hitting the annual contribution limit, the employee’s take-home pay will increase by $700 or so. The exact amount will depend on income tax withholding calculations. They will enjoy that higher take-home pay through the last paycheck for the year. In January, the process starts all over again and payroll will automatically start deducting the employee’s retirement plan contribution again. This, of course, causes their take-home pay to drop back down by several hundred dollars.
Social Security Contributions
While most people are aware that there’s a maximum amount an employee can contribute to a retirement plan, they are not as aware that there is a similar Social Security annual maximum. Before we dive into this topic, it’s important to point out that an employee’s Social Security and Medicare deductions are two different percentages and are subject to different rules. For the sake of brevity, we’re not discussing Medicare deductions here – just Social Security.
Here are the basics. An employer is required by law to deduct 6.2% from an employee’s gross pay and forward that money to the Social Security Administration for the employee’s account. In addition, the employer is required to pay that same 6.2% from their “pocket” and send it to the Social Security Administration for the employee. So the employee’s total credit is 12.4% every pay; half is from the employee and half is from the employer. When someone is self-employed, they pay that entire 12.4% themselves.
While most people know that a percentage of their pay is deducted for Social Security, what they aren’t aware of is that there is an annual limit. In 2021, the maximum that was deducted from an employee’s pay for Social Security was $8,853.60. In 2022, that maximum increases to $9,114.00 because they adjust it for inflation every year.
If your gross wages (salary and bonus) are going to exceed $147,000 in 2022, then the Social Security deduction will stop when you hit the limit. Payroll automatically takes care of it.
As we saw in the example above for retirement plans, this can impact a person’s take-home pay. Someone with a gross salary of $100,000 won’t hit the limit and therefore their take-home pay will stay the same throughout the year. A person with a gross salary of $200,000 will see their take-home pay increase in the Fall when they hit the limit. It will go back down in January when Social Security is deducted again. Someone with a base salary of $200,000 who also receives a bonus will hit the maximum even sooner.
We’ll also note that for executives with employer stock-based compensation, that compensation is also subject to Social Security and Medicare deductions.
We hope that sheds some light on the two most common reasons a person’s take-home pay can fluctuate significantly over the year.
