Just because you make a certain salary doesn't mean you get to take home your earnings in full. Once you apply state and federal payroll taxes to your wages, the amount you'll get in each paycheck will be considerably lower than your base income. Whatever number you're left with all after taxes are taken out is known as your after-tax income, and that's the amount of money you'll have at your disposal to spend on living expenses, save, or invest.
Calculating after-tax income
If you're a salaried worker, you don't need to do much to calculate your after-tax income, because the net amount listed on your paychecks will represent that figure. If you get paid via direct deposit, the amount that gets filtered into your bank account each pay period is your after-tax income.
Imagine you earn $50,000 a year and you don't allocate pre-tax dollars to a retirement account or flexible spending account. If your total tax liability equals $18,000, then your after-tax income for the year will be $32,000. Simple.
After-tax income and budgeting
Following a budget is one the best ways to keep your spending in check and ensure that you're on track for meeting your financial goals. But when you create your monthly budget, be sure to base your calculations on your after-tax income. If your pre-tax income per month is $5,000 but your after-tax income is only $3,600, you'll need to make sure your spending doesn't exceed that lower threshold.
It's especially important to pay attention to after-tax income if you're thinking of getting a mortgage. As a general rule of thumb, your housing costs, including property taxes and homeowners' insurance premiums, should never exceed 30% of your after-tax income. Using our last example, if your after-tax income is $3,600 a month, then you'll need to keep your housing expenses to $1,080 a month or less.
Pre-tax versus after-tax retirement savings
When saving for retirement, you'll often have the option to contribute either pre-tax or after-tax dollars to your IRA or 401(k). If you put money into a traditional 401(k), your employer will subtract those contributions from your gross pay and then apply all applicable state and federal taxes to your remaining income. As a result, you won't pay taxes on your contributions the year you make them.
Say your gross income is $5,000 a month but you allocate 10% of that to your 401(k). Your employer will first deduct $500 and set it aside before taxing the remaining $4,500. If your effective tax rate is 25%, you'll save $125 a month by contributing to your retirement account, because you'll get to avoid taxes on $500 of income.
Roth IRAs (and 401(k)s, though they're less popular) work the opposite way. When you fund a Roth account, you're contributing money from your after-tax income, which means your gross income is taxed in full and you don't get any immediate tax benefit for your contribution. The plus side is that when the time comes to take withdrawals in retirement, you'll collect that money tax-free. Traditional IRA and 401(k) withdrawals, on the other hand, are taxed in retirement, so while you'll get a tax benefit up front, you'll owe the IRS its share down the line.
In an ideal world, you'd get to keep all of your income, but as we all know, that's just not the way things work. Understanding the difference between pre-tax and after-tax income can help you make smart financial decisions and budget accordingly.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at email@example.com. Thanks -- and Fool on!
The Motley Fool has a disclosure policy.