Health Insurance Premiums Affect Your Paycheck

How Health Insurance Premiums Affect Your Paycheck and Save Taxes

If you have elected family health coverage through your employer and your premiums are $350 a month then it would be easy to think that the net effect on your paycheck would be $350 a month.[1]  However, there is more to it than that, and to fully understand your paycheck you need to know the positive effects that your heath insurance premium payments have on your payroll-related calculations.

Health insurance premium contributions reduce your FICA (or payroll) taxes

If your employer deducts your health insurance premiums directly from your paycheck (as opposed to you writing a check to pay for health insurance) then it saves you taxes by lowering your FICA wage base.  Note that Social Security and Medicare taxes combined together are known as “FICA” or “payroll” taxes.  A comprehensive example of how to calculate your taxable FICA wages, as well as how health insurance premiums fit into that.  However, just focusing on health insurance for now, here is an illustration of how your employee-sponsored health insurance premiums reduce your FICA taxes.[2]

What this example shows is, all things being equal, if your health insurance premiums are deducted from your paycheck then it will lower your taxable FICA wages by $350, and will result in a FICA tax savings of $19.77 a month (or $237.24 a year).

Health insurance premium contributions save you even more on income taxes

Following the principles above relating to FICA taxes, employer-sponsored health insurance contributions also result in substantial savings on your Federal and state income taxes, which is illustrated as follows.[3]

Based on these figures, being able to purchase health insurance through your employer would lower your income tax base by $350, and that would save you $73.50 a month (or $882.00 a year) in income taxes.

Summary

Having health insurance premiums deducted from your paycheck saves you a substantial amount in taxes.  Why?  Because it because it reduces your taxable wage base before FICA, Federal and state income taxes are applied. Based on the figures in the examples above, your combined FICA and income tax savings would be $93.28 a month ($19.78 plus $73.50) or $1,119.36 a year ($93.28 x 12 months).[4]  That’s a substantial amount of money for a regular person!  As a result, in evaluating your overall financial situation it’s very important to not only consider the availability of health insurance through your employer, but to take into account the tax-related benefits of health insurance contributions as well.



[1] The average annual cost of family health insurance premiums in 2010 was $13,770.  Of that, employees had to cover approximately 27%, or $3,718.  That averages out to be about $310 a month, which I have rounded up to $350 due to the higher cost of health insurance in many parts of the country.  For reference, see http://ehbs.kff.org/?page=charts&id=1&sn=6&p=1 and http://www.consumerhealthratings.com/index.php?action=showSubCats&cat_id=179.

[2] The FICA tax rate of 5.65% is based on the 2011 Social Security tax rate of 4.2% plus the Medicare tax rate of 1.45%.  As of this writing the 4.2% Social Security tax rate is slated to expire at the end of 2011 when it will go back to 6.2%, but it’s not yet clear whether the law will be extended, modified, or allowed to expire.

[3] The 21% tax rate assumes a 15% Federal tax rate and a 6% state tax rate.

[4] Looking at this another way, the net cost of your health insurance wasn’t $350, but $256.73 (the $350 premium less tax savings of $93.28).

How Social Security Tax & Medicare Tax (or FICA) Work

“I want to find out who this FICA guy is and how come he’s taking so much of my money.” – Nick Kypreos (former professional hockey player).

Payroll taxes are based on your taxable (rather than gross) wages

The combined total of your Social Security and Medicare taxes are often referred to as “payroll taxes, ” “FICA,” or “FICA taxes.”[1]  The Medicare tax rate on wages is 1.45%.  Since 1990 the Social Security portion of FICA has been 6.2% of wages, but for 2011 only the rate was cut to 4.2% as a means to stimulate the economy.  Given this is the case, if your salary was $50,000 a year then it would be natural to assume that your monthly Social Security and Medicare taxes would be $235.42, which paystub breakdown is calculated as follows (assuming that the temporary 4.2% Social Security rate applies to this and the other examples that follow).[2]

How FICA Tax Works 1

What if I told you instead that your actual payroll taxes were $184.47, or $50.95 less than what you expected ($235.42 less $184.47)?  What accounts for the difference?  Exactly how is the Social Security and Medicare tax breakdown on your paycheck calculated?  To answer that the most important thing you need to understand is that Social Security and Medicare taxes are not driven by gross monthly wages, but by your taxable wages.  This is illustrated by the following example, which shows how the $184.47 of payroll taxes referred to above was calculated.[3]

How Social Security Tax Works 2

Again, a key thing to take away from this example is that by default your gross wages or salary (the $4,166.67) is the starting point for calculating your payroll taxes, but there certain things which can either increase or decrease your taxable FICA wage base.  In the example above you received $15 in non-cash taxable fringe benefits, and that served to increase your FICA taxable base.  On the other hand, your health insurance premiums and “FSA” (or “flexible spending account”) contributions served to decrease your FICA taxable base.  Thus, after taking into account all of the adjustments shown above, your taxable FICA wage base decreased from $4,166.67 (your gross monthly wages) to $3,265.00.

Why calculate Social Security and Medicare taxes separately?

If you compare the Social Security and Medicare tax calculations above you’ll notice the only difference between the two is that the tax rates are different (4.2% vs. 1.45%).  If that’s the case then why calculate the two taxes separately?  Why not just take your taxable FICA wages ($3,265.00) and multiply it by 5.65% (4.2% plus 1.45%) to arrive at your total FICA taxes of $184.47 ($137.13 plus $47.34)?  There answer is that will actually work for most people.  However, there are two reasons you need to be able to calculate your Social Security and Medicare taxes separately.

  1. The two taxes almost always appear on your paystub as separate figures rather than as one combined FICA tax, so it’s important that you know how to check each of them individually.
  2. If your taxable wages happen to be in excess of $106,800 (congratulations!) then it throws the math off, because wages in excess of that amount are exempt from Social Security taxes whereas all wages are subject to Medicare taxes.[4]

Verify that your payroll taxes are calculated correctly on your paystub

Now that you understand the principles behind calculating Social Security and Medicare taxes, pull out your last paystub and verify that your own FICA taxes are being calculated correctly.  If you’re able to successfully do so then feel free to skip to the “Summary” paragraph at the end of this article. If, however, you’re still having trouble verifying that the Social Security and Medicare taxes on your own paystub are being calculated correctly then you first need to determine what your employer is using as your taxable FICA wage base.  You do that by dividing the Medicare taxes on your pay stub ($47.34 in our example) by the Medicare tax rate (1.45%), illustrated as follows.[5]

FICA Tax or Medicare

Do you see what you’ve done?  Using the formula above you’ve mathematically determined that, according to your company’s payroll department, your taxable Medicare wages are $3,264.83.  That’s significant because remember, by default, Medicare taxes are based on your gross wages.  Therefore, if your gross wages ($4,166.67) are not equal to your taxable Medicare wages ($3,264.83) then it means they’ve have been adjusted for payroll tax purposes, and the amount of the adjustment can be calculated as follows.

FICA Tax

So how do you account for this difference of $901.84 between your gross monthly wages and your taxable Medicare wages?  Referring back to earlier illustrations in this article, you will find the following:

Social Security Tax FICA Tax

What this shows is that after you take into account payroll tax (or FICA) deductions related to your health insurance and flexible spending account contributions, you can fully explain the difference between your gross wages and your taxable Medicare wages except for a fairly small difference of $14.83.  Not bad.  But wait, if you think about what you read in the previous article about non-cash fringe benefits then does that give you an idea of what the difference could be?  It’s very close to the $15 of taxable fringe benefits that you received (see above), and when you add those back then your reconciliation is only off by 17 cents.[6]

How FICA Tax Social Security Tax Work

In summary, you can verify that your Medicare tax ($47.34) is correct by verifying that your Medicare tax base ($3,265.00) is correct.  In addition, once you’ve verified your Medicare tax base, you can use the following method to verify that your Social Security taxes are also being calculated correctly.[7]

How FICA Tax Social Security Tax Work

Summary

So what’s the point of this whole exercise?  After all, isn’t your company’s payroll department supposed to ensure that your Social Security and Medicare taxes are being calculated correctly?  Of course they are, but if you’re serious about managing your money then you shouldn’t just blindly fork over $184.47 ($137.13 in Social Security and $47.34 in Medicare taxes) to the government every month unless you know why.  No, if you’re serious about managing your money then you’ll make the effort to independently verify that your payroll taxes are being calculated correctly.  If you’re unable to do so then contact your employer’s payroll department and have them walk you through how they came up with the numbers on your paystub.


[1] FICA stands for “Federal Income and Contributions Act,” which is where the federal government derives its authority to levy payroll taxes.  Source: Internal Revenue Code Section 3101.

[2] For purposes of this example and the ones below it’s assumed you are paid on a monthly basis.  However, the same principles apply if you are paid bi-monthly, weekly, etc.

[3] The figures in this example are drawn from my introductory article on how to read checks.

[4] The $106,800 Social Security wage base is accurate for 2017 (it’s adjusted annually for inflation).  See http://ww.ssa.gov/oact/cola/cbb.html.  For more information how to handle high wages and other special issues related to Social Security tax calculations click here.

[5] Why is it important to use the Medicare rather than the Social Security tax rate to determine your taxable FICA base?  The reason is that Medicare doesn’t have a taxable wage ceiling, so the formula will work every time.  On other hand, because the Social Security wage base is capped at $106,800 (2011) then the formula won’t work if your wages happen to be in excess of that amount.  If you find this confusing then just remember that it boils down to this: use the Medicare tax rate of 1.45% in the formula!

[6] You don’t need to contact your payroll over an amount as small as 17 cents; it’s just a rounding difference.

[7] Note that if your taxable FICA wages are in excess of $106,800 (based on 2017 figures) then your Social Security taxes for the year should be capped at $4,485.60 ($106,800 times 4.2%).

How to read checks pay stub meaning

How To Read Checks – Pay Stub Explained

Understand Pay Stub Meaning & How To Read Checks

Some of your most expensive bills are in your paycheck

In order to manage your money effectively you need to have a clear understanding of all of your expenses.  What many people either forget or don’t realize is that some of their most expensive bills don’t show up in the mail, but in their paycheck!  For example, if your salary is $50,000 a year and you’re paid once a month then your gross monthly wages (or salary) would be calculated as follows.[1]

Pay Stub Meaning & How To Read Checks

What this means is barring any complicating factors, you should expect to receive exactly $4,166.67 each month.  But of course things are not that simple because, as anyone who has ever gotten a paycheck knows, there are complicating factors!  As it relates to our example, what if I told you that instead of your take-home pay (meaning the amount of money that actually made it to your bank account) being $4,166.67, it was only $2,482.11?  What’s going on here?  How can your net pay be $1,684.56 less than what you earned, an amount that’s over 40% of your total paycheck?  In short, what financial sharks devoured massive chunks out of your monthly earnings before they ever even got to your bank account?!?

How To Read Checks – Sample Paycheck Breakdown

Based on the figures above, the following breakdown accounts for the $1,684.56 reduction in gross pay of $4,166.67, to arrive at a net paycheck of $2,482.11.

Gross Wages (or Base Monthly Salary)$4,166.67
  
Less: Health Insurance($350.00)
Less: FSA – Medical($166.67)
Less: FSA – Dependent Care($400.00)
  
Less: Retirement Plan Contribution($416.67)
  
Less: Social Security($137.13)
Less: Medicare($47.34)
Less: Federal Income Tax($65.83)
Less: State Income Tax($105.92)
  
Less: Disability Insurance($30.00)
Less: Company Deductions($45.00)
Add: Reimbursements$80.00
  
Equals: Net (or Take-Home) Pay$2,482.11

It’s important to note here that not everything that’s taken out of your paycheck is bad.  For example, the $416.67 contribution to your retirement plan will certainly help you in the future, but you also need to take into account that it’s $416.67 less in the current month that you’ll have to pay the bills, cover day-to-day expenses, and do other things you would need or like to.

Know where every penny of your paycheck is going and why

Fully understanding the breakdown of your paycheck is one of the great mysteries of the known universe.  To cut through all the complexity, my approach to paycheck analysis boils down to this: if your employer has agreed to pay you $4,166.67 a month then you should expect them to deposit exactly that much each month into your bank account, and if you get any less ($1,684.56 less in our example!) then you should figure out where every penny went and why.  The purpose of this article is to give you with a starting point to do just that, by providing you with links to relevant paycheck-related information, examples, and insights (see below).

Related articles and information

To continue this series and read the next article on how to read your paycheck.   Also, you can click on any of the links in the sample paycheck breakdown above if you want to go straight to information on a specific area of your paycheck.  Finally, you can also refer to other information on taxes.

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[1] According to government statistics, the median income of a household in the United States in 2018 was $61,372 (see https://www.census.gov/newsroom/press-releases/2018/income-poverty.html).  While that figure is a bit dated, rounding it to $60,000 to make my examples easier to follow.