Semimonthly Payroll and a 401(k) Contribution Increase
Devon is a salaried nonexempt employee paid semimonthly. His gross pay each pay period is $3,240. He contributes 5% of gross to a traditional 401(k). His health insurance premium is $145 per pay period and is deducted under a Section 125 cafeteria plan, so it reduces both income-tax and FICA wages. The 401(k) contribution reduces federal and state income-tax wages but does not reduce FICA wages. Federal income tax withholding is $410 per pay period, based on his current W-4. State income tax is 4.2% of taxable wages after the 401(k) and Section 125 deductions. Social Security is 6.2% and Medicare is 1.45%; Devon has not reached either wage base. Devon is considering raising his 401(k) rate to 8%. His payroll clerk says the raise will cut take-home pay by the full extra contribution, but Devon thinks the tax savings will soften the blow.
1. Compute Devon's net pay at the 5% 401(k) rate, showing each deduction.
Read the worked answer
401(k) contribution = 5% x $3,240 = $162.00.
State taxable wages = gross - 401(k) - Section 125 health premium = $3,240 - $162 - $145 = $2,933. State income tax = 4.2% x $2,933 = $123.19.
FICA wages = gross - Section 125 health premium = $3,240 - $145 = $3,095. The 401(k) does not reduce FICA wages. Social Security = 6.2% x $3,095 = $191.89. Medicare = 1.45% x $3,095 = $44.88.
Net pay = $3,240 - $162 - $145 - $410 - $123.19 - $191.89 - $44.88 = $2,163.04.
Check the order: $3,240 - $162 = $3,078; minus $145 = $2,933; minus $410 = $2,523; minus $123.19 = $2,399.81; minus $191.89 = $2,207.92; minus $44.88 = $2,163.04.
2. Compute the per-paycheck change if Devon raises the 401(k) rate to 8%, assuming federal withholding falls by 22 cents per dollar contributed and state by 4.2 cents, while FICA is unchanged.
Read the worked answer
New 401(k) contribution = 8% x $3,240 = $259.20. Extra contribution = $259.20 - $162.00 = $97.20 per paycheck.
Federal tax saving = 22% x $97.20 = $21.38. State tax saving = 4.2% x $97.20 = $4.08. FICA saving = $0 because traditional 401(k) contributions are not subject to FICA.
Net take-home reduction = extra contribution - tax savings = $97.20 - $21.38 - $4.08 = $71.74 per paycheck.
New net pay is approximately $2,163.04 - $71.74 = $2,091.30.
Over 24 semimonthly pay periods, Devon would contribute an extra $2,332.80, save about $611.04 in federal and state income tax, and reduce annual take-home pay by about $1,721.76.
3. Evaluate the payroll clerk's statement and advise Devon.
Read the worked answer
The clerk is wrong to say take-home pay falls by the full extra contribution. Because the 401(k) is pre-tax for federal and state income tax, each extra dollar contributed reduces taxable wages and therefore reduces withholding. At a 22% federal marginal rate and 4.2% state rate, the net cash reduction is about 73.8 cents per extra dollar, not one dollar.
Still, Devon's take-home pay does fall. He should confirm that the employer offers a matching contribution, because a match is an immediate return that may make the increase clearly worthwhile. He should also check liquidity: retirement money is less accessible, so he should not contribute so much that he cannot cover emergencies or high-interest debt.
If Devon has an adequate emergency fund and no costly debt, raising the rate to 8% is reasonable: he adds $97.20 per paycheck to retirement while giving up only about $71.74 in current cash, and he lowers his taxable income.