Before you dive into budgeting, saving, and investing, it’s important to make sure that you know how to read your paycheque. After all, we can only save and invest money that we’ve earned in the first place.
Here, we’ll dig into these key concepts:
- Gross salary
- Net salary (also known as take-home pay)
When people talk about their annual salary (e.g., $40,000 per year) or hourly salary ($20 per hour), they are almost always talking about “gross salary”. This is the headline number that appears on your employment contract.
This figure is only a starting point.
Unfortunately, the money that appears in our bank account after each pay day is lower than what our gross salary would suggest. Think of your gross salary as the entire pie. After taking off slices for taxes and deductions (discussed below), the remainder is of the pie is what actually gets deposited into our bank account.
It’s morbid but true: ’Tis impossible to be sure of any thing but death and taxes.
When you earn money from your job, your employer will automatically subtract taxes off of your gross salary (boo). Your employer sends this money to the government on your behalf.
The main form of tax taken off from your paycheque is income tax. The amount of income taxes you pay are based on the concept of “tax brackets”. As your income gets higher, the percentage of your income that you pay in tax increases — but only on the extra portion.
Here’s an overview of Canadian income tax brackets:
Side note #1: It’s a common misconception that you should try to stay below certain income levels, since shifting into a new tax bracket would reduce your overall take-home pay (i.e., higher salary but lower money coming into your bank account at the end of the day). This is absolutely NOT true.
When you move into a higher tax bracket, it’s only the money earned within that new bracket which is taxed a the higher rate, not your entire salary.
However, you may see a higher amount of tax withheld (see below) when you have a big, unusual paycheque (e.g. a bonus), because of the way tax withholding is calculated for paycheques.
Side note #2: The taxes taken off your paycheque are a “withholding” tax, meaning that they are just an estimate of the amount that you should owe. At the end of the year, the actual amount of taxes that you should have paid will be calculated on your tax return. The resulting difference between what you paid and what you should have paid will be settled at that point (either through a tax refund or additional taxes owed).
Keep this in mind if you see something odd happen with your taxes on your paycheque (for example, when you receive a bonus). You will always get “trued-up” at the end of the year.
The bottom line: the higher your income, the more tax you pay. However, making a higher income will always increase the pay that hits your bank account.
Depending on what company you work for, you may have other deductions that are taken off of your paycheque. These could include contributions to an employer stock option plan, an employer pension / retirement savings plan, or an employer health plan.
When you were first hired, HR may have given you forms to sign up for an employer retirement savings plan (often known as a “Group RRSP” account in Canada). If you signed up, you’d be contributing a portion of your paycheque towards these savings plans (e.g., contributing 2% of each paycheque towards that account).
These amounts are deducted directly from your paycheque. As such, this money never arrives in your bank account. Instead, it’s held separately in a different account.
Net Salary (Take-Home Pay)
Gross salary is the full pie that we start with. After taking off a slice for taxes, and another slice for deductions, the amount of the pie remaining is what’s known as net pay or take-home pay. This is the amount of money that actually gets deposited into your bank account.
Your take-home pay is the most important number for you to know, since ultimately this is the money that you have control over. This is the money that pays the bills or gets saved for the future.
Knowing the amount of money that you take home each month will serve as a key input for your financial plan.
An Illustrative Example
Let’s take an example from a hypothetical Canadian paycheque:
- For these two weeks, John earned a gross salary of $1,140 (regular pay plus overtime pay)
- John paid total taxes of $239.97. This consisted of income tax, employment insurance (EI), and Canada Pension Plan (CPP) payments
- John also had deductions of $104 for health insurance, registered pension plan, union dues, and Canada savings bonds
- As a result, John had take-home pay of $796.03 for these two weeks ($1,140 minus taxes of $239.97 and minus deductions of $104)
- John’s average tax rate was 21% for this paycheque (total taxes of $239.97 divided by gross pay of $1,140)