5.1 - Taxes, Net Income, and Budgeting
Types of Taxes Paid by Individuals
Individuals pay taxes to federal, state, and local governments, and the main types include income taxes, capital gains taxes, specific payroll taxes, property taxes, and sales taxes. The exact types and amounts vary depending on the state.
Each level of government leans on different taxes. The federal government collects income taxes (including capital gains taxes) and payroll taxes. Most states collect their own income tax and a sales tax. Local governments, like counties, cities, and school districts, rely mostly on property taxes, and some add a local sales tax. That's why the mix varies so much by location. For example, Texas and Florida have no state income tax on wages, while Oregon and Delaware have no statewide sales tax.
Income tax is a percentage of income paid to the government. For employees, the employer withholds part of each paycheck and sends it to the government, and individuals file an annual tax return that might result in owing more money if they underpaid throughout the year, or getting a refund if they overpaid. Self-employed individuals have to handle submitting their own income taxes directly.
In the U.S., a new employee fills out a Form W-4, which tells the employer how much federal income tax to withhold from each paycheck. After the year ends, the employer sends a Form W-2 showing total pay and total tax withheld, and the household uses it to file a tax return, usually due by April 15. If more was withheld than the household actually owes, the difference comes back as a refund. If less was withheld, the household pays the rest. Since no employer withholds for self-employed people, they usually send in estimated tax payments four times a year.
Capital gains taxes apply when someone earns a capital gain, meaning profit from selling an asset for more than they paid for it. These get reported along with the regular income tax return but are usually taxed at a different, often lower, rate.
Example: you buy shares of stock for $2,000 and sell them two years later for $3,000. Your capital gain is $3,000 minus $2,000 = $1,000, and only that $1,000 gets taxed (not the full $3,000). In the U.S., how long you held the asset matters. Long-term gains (assets held more than a year) are taxed at federal rates of 0%, 15%, or 20%, depending on income (as of 2025). Short-term gains (assets held a year or less) are taxed at the same rates as regular income. So someone in the 22% bracket would usually pay 15% on a long-term gain ($150 on this $1,000) instead of 22% ($220). A gain on something you own isn't taxed until you sell it.
Payroll taxes fund specific government insurance programs. In the U.S., the main ones are Social Security and Medicare, and these taxes are withheld from paychecks. Employers pay a matching amount, so they cover half of these taxes, while self-employed people and many contract workers pay the full amount themselves. Unemployment benefits are funded by a separate payroll tax that employers pay almost entirely on their own. Medicaid, which covers health care for people with low incomes, is mostly paid for out of general federal and state tax revenue rather than payroll taxes.
On a U.S. pay stub, these show up as Social Security (6.2% of pay, up to a yearly earnings cap) and Medicare (1.45% of all pay), often grouped together as FICA taxes (rates as of 2025). The employer pays a matching 6.2% and 1.45% on top of that. For example, on a $1,000 paycheck the worker pays $62 for Social Security and $14.50 for Medicare ($76.50 in total), and the employer pays another $76.50. Self-employed people pay both halves themselves, 15.3% in total, called self-employment tax.
Property taxes are based on the value of property like houses, land, or cars, and depending on where someone lives, they might be paid annually, semi-annually, or monthly.
Property taxes are mostly collected by local governments and pay for things like public schools, roads, police, and fire departments. The bill is usually the property's assessed value times the local tax rate. For example, a home assessed at $250,000 with a 1.2% property tax rate owes $250,000 × 0.012 = $3,000 a year, or $250 a month. Homeowners with a mortgage often pay this monthly as part of their mortgage payment, and the lender pays the tax bill for them out of an escrow account. Renters don't get a property tax bill, but landlords usually build the cost into the rent.
Sales taxes are based on the sale price of an item, collected by the business at the point of sale, which then passes those payments along to the government.
Example: a $40 shirt in a place with a 7% sales tax costs $40 × 0.07 = $2.80 in tax, so you pay $42.80 at the register. Rates differ by state and even by city, and some states don't tax certain items, like groceries.
Why People Pay Different Federal Income Tax Amounts
How much someone pays in federal income tax depends on their income level, tax deductions, and tax credits. The U.S. federal income tax system, along with some state systems, is progressive, meaning higher income gets taxed at higher rates on the portion that falls into higher brackets.
The key idea is the marginal tax rate, the rate paid on the next dollar of income. Income is split into brackets, and each bracket's rate applies only to the income inside that bracket. That makes the effective tax rate (total tax divided by taxable income) lower than the top bracket rate a person reaches. Here's an example with simplified brackets for someone with $60,000 of taxable income:
Bracket (taxable income) | Rate | Income taxed at this rate | Tax |
$0 to $10,000 | 10% | $10,000 | $1,000 |
$10,001 to $40,000 | 12% | $30,000 | $3,600 |
$40,001 to $90,000 | 22% | $20,000 | $4,400 |
Total | $60,000 | $9,000 |
This person's marginal rate is 22%, but their effective rate is $9,000 ÷ $60,000 = 15%. A common myth is that a raise can push you into a higher bracket and leave you with less money. It can't, because only the dollars above the bracket line are taxed at the higher rate. (As of 2025, the real U.S. federal brackets have seven rates, from 10% to 37%, and the dollar cutoffs change every year and depend on filing status, like single or married filing jointly.)
Tax deductions reduce someone's taxable income, which lowers what they owe. Common deductions include mortgage interest, retirement account contributions, charitable donations, state and local taxes paid, and certain medical expenses. Since taxable income equals gross income minus deductions, a lower taxable income means a lower total tax bill.
Taxpayers choose between the standard deduction, a flat amount set by law that depends on filing status, and itemizing, which means adding up their actual deductible expenses (like mortgage interest, state and local taxes, charitable gifts, and large medical bills). They take whichever is bigger, and most households take the standard deduction. Pretax retirement contributions, like those to a traditional 401(k), lower taxable income either way.
A deduction is worth the amount deducted times your marginal tax rate. Using the bracket example above, a $1,000 deduction drops taxable income from $60,000 to $59,000, and the tax falls from $9,000 to $8,780. That saves $220, which is 22% of $1,000.
Tax credits work differently, directly reducing the tax owed dollar for dollar. Examples include the child tax credit, child or dependent care credit, education credits, and various credits tied to specific purchases or behaviors depending on current law. Since final tax owed equals tax before credits minus credits, more credits mean less tax owed, and potentially a bigger refund.
That makes a credit worth more than a deduction of the same size. In the same example, a $1,000 tax credit cuts the tax from $9,000 to $8,000, saving the full $1,000, compared with $220 for a $1,000 deduction. Some credits are refundable, meaning that if the credit is bigger than the tax owed, the household gets the difference back as a refund. Nonrefundable credits can only bring the tax down to zero.
Putting it together: two households with the same income can owe very different amounts. A family with mortgage interest, charitable gifts, and two children who qualify for the child tax credit will usually owe less than a single person with the same income who just takes the standard deduction and has no credits.
Components of a Pay Stub
A pay stub typically shows gross income, mandatory deductions, voluntary deductions, and net income.
Gross income is the total amount earned during a pay period, determined by dividing an annual salary by the number of pay periods, multiplying hours worked by hourly wage, using a specific contracted amount, or some other compensation scheme like commission.
To find gross pay per paycheck, divide the yearly salary by the number of pay periods: weekly (52 a year), biweekly, meaning every two weeks (26), semimonthly, meaning twice a month (24), or monthly (12). A $52,000 salary paid biweekly is $52,000 ÷ 26 = $2,000 per paycheck. For hourly workers, gross pay is hours worked times the hourly wage, so 40 hours at $18 is $720. Under U.S. federal law, most hourly workers also earn overtime of at least 1.5 times their regular rate for hours over 40 in a week, so 45 hours at $18 would be $720 + (5 × $27) = $855.
Mandatory deductions are required by federal, state, or local law, and employers must withhold them. These typically include income taxes and specific payroll taxes like Social Security and Medicare.
Voluntary deductions are chosen by the employee, like contributions to health insurance, health or dependent care savings plans, life insurance, retirement accounts like a 401(k), or union dues. Some of these deductions are pretax, meaning that money isn't counted as part of taxable income, which reduces the overall tax bill and can encourage saving.
Net income, or net pay, is what's actually left after all deductions, mandatory and voluntary, and it's the amount that shows up on the actual paycheck, which can end up quite a bit lower than gross income.
Here's a sample biweekly pay stub for someone earning $52,000 a year who puts 5% of pay into a 401(k) and belongs to a union:
Pay stub item | Type | This pay period |
Gross pay ($52,000 ÷ 26) | $2,000.00 | |
Federal income tax | Mandatory | $150.00 |
State income tax | Mandatory | $55.00 |
Social Security (6.2%) | Mandatory | $124.00 |
Medicare (1.45%) | Mandatory | $29.00 |
401(k) contribution (5%, pretax) | Voluntary | $100.00 |
Union dues | Voluntary | $20.00 |
Total deductions | $478.00 | |
Net pay | $1,522.00 |
Mandatory deductions add up to $358 and voluntary deductions to $120, so net pay is $2,000 minus $478 = $1,522, only about 76% of gross pay. Because the 401(k) contribution is pretax, income tax is figured on $1,900 instead of $2,000. (Social Security and Medicare still apply to the full $2,000, since 401(k) contributions are still charged those two taxes.) The federal and state income tax amounts depend on the worker's W-4 and their state. Real pay stubs also usually show year-to-date (YTD) totals for each line, which is handy for checking that withholding is on track.
Using Net Pay to Build a Budget
A budget should be built on net pay, not gross pay, since net pay is what actually reaches the bank account. Someone earning $52,000 a year might picture $4,333 a month ($52,000 ÷ 12), but with the pay stub above, two paychecks bring in $3,044. Biweekly pay means 26 paychecks a year, so most months have two paychecks and two months have three. Many people budget on two paychecks a month and send the extra checks straight to savings or debt. (3.6 walks through a full monthly budget built on net pay.)
A budget lists income, planned savings, and expenses. Fixed expenses stay about the same every month (rent, a car payment, insurance premiums, a phone plan). Variable expenses change from month to month (groceries, gas, utilities, eating out). Income minus savings and expenses leaves either a surplus (money left over) or a deficit (spending more than comes in, which means pulling from savings or borrowing). A popular benchmark for checking a budget is the 50/30/20 rule: about 50% of net pay for needs, 30% for wants, and 20% for savings and extra debt payments.