Of your many responsibilities as a small business owner, ensuring that employees' pay is calculated accurately ranks near the top of the list. This means withholding the correct amounts for federal income tax, state income tax, Social Security and Medicare. You also need to factor in other deductions, such as those for employee health insurance premiums and contributions to retirement accounts.
Failure to make the proper deductions from an employee's wages or salary could get you in trouble not only with your staff but also with the IRS. However, preventing the legal and employee-related headaches that stem from payroll mistakes isn't difficult if you know how to properly alculate gross pay and net pay.
What is gross pay?
Gross pay is the amount of an employee's salary or wages before any deductions. For example, if an employee has a salary of $35,000 per year, that employee's gross pay is $35,000. The gross pay of an hourly employee who works 30 hours and makes $15 per hour is $450 for that pay period.
For an hourly employee, wages can include breaks, on-call time, overtime, travel time and training. Gross pay is the starting point for all calculations related to tax and employee compensation. [Looking for payroll software to take these calculations off your plate? Check out our recommendations for the best online payroll software]
What is net pay?
Net pay, commonly called "take-home pay," is the amount paid to employees after federal, state and local income taxes, as well as other deductions for health insurance premiums and contributions to retirement accounts, have been withheld from their gross wages or compensation.
How to calculate gross pay
Because you don't pay employees for an entire year of work in a single paycheck, you need to know how to calculate gross and net pay for each pay period, which could be weekly, biweekly, semimonthly or monthly.
Follow these steps to calculate gross pay per pay period for a salaried employee:
1. Divide the annual gross pay by the number of pay periods in the year.
For example, if an employee has an annual salary of $35,000 and you pay them biweekly, this would be the calculation:
$35,000/26 = $1,346.15
2. Add bonuses and commissions, if applicable.
The next step is to add any additional compensation the employee may have earned during the pay period. For example, if your business offers an annual holiday bonus of $100 per employee, payable in the last paycheck of the year, you would add $100 to the employee's gross pay for the pay period. Using the example above, this would be the calculation:
$1,346.15 + $100 = $1,446.15
Follow these steps to calculate gross pay for an hourly employee:
1. Multiply the hourly wage by the number of hours worked during the pay period for which you're writing paychecks.
For example, if an employee is paid $15 per hour and worked 20 hours over a two-week pay period, this would be the calculation to determine their gross pay for the pay period:
$15 x 20 = $300
2. Factor in overtime.
The next step is to add any overtime the employee may have worked. If you pay time and a half for overtime hours, the employee would receive the regular hourly wage of $15, plus another $7.50 for each extra hour on the job. So, if the employee above worked 5 hours of overtime, this would be the calculation to find their gross pay:
$300 + ($7.50 x 5) = $337.50
Calculating net pay
Calculating an employee's net pay for any pay period involves subtracting tax withholding and other payroll deductions from the gross pay for that pay period. Start with gross pay for the pay period. Then, follow these steps:
1. Make voluntary pretax deductions.
Items in this category are deductions that aren't required by law. Rather, employees opt to have them withheld from their paycheck to lower their taxable income and payroll taxes. Contributions to a retirement account, such a 401(k); some health benefits; and commuter benefits qualify as voluntary pretax deductions.
Pretax deductions are taken before mandatory payroll taxes are applied. For example, if an employee contributes $75 per paycheck to a 401(k) plan and $50 per month to their health insurance premium, you would subtract those two amounts from their gross pay to figure out their net pay.
2. Subtract federal tax withholding (mandatory payroll tax).
Here, you'll need information about the employee's filing status (single, married filing jointly, married filing separately, head of household, and widow or widower with dependent child) and withholding allowance. The withholding allowance refers to exemptions a taxpayer can lawfully take from his or her income to reduce the amount of income that would otherwise be taxed. Each exemption drives down the amount of tax you can deduct from an employee's paycheck.
You can find filing status and withholding allowance details on IRS Form W-4, Employee's Withholding Allowance Certificate, which an employee must complete and submit to you upon starting work at your company. It's illegal for an employer to assist an employee in filling out Form W-4, but you're allowed to refer those who need help doing so to a withholding estimator tool available from the IRS.
You also need the IRS' tax withholding tables, which, starting in 2020, can be found in the agency's Publication 15-T. IRS Publication 15-T (2021)-Federal Income Tax Withholding Methods contains the most current tables. The tables provide the correct percentage of federal income tax withholding from gross wages, based on an employee's filing status, withholding allowance and the range into which the employee's salary falls.
3. Deduct state and local tax withholding (mandatory payroll tax), if applicable.
Unlike federal tax withholding, state tax withholding rates vary from state to state. There's no withholding to consider in Alaska, Florida, Nevada, South Dakota, Texas, Washington or Wyoming, as these states don't tax income. Likewise, state withholding doesn't come into play in New Hampshire and Tennessee, because both states tax only interest and dividend income, not salary and wages.
You may need to deduct state income tax from more than one state if an employee works in one state and lives in another. However, some states maintain reciprocity agreements and don't tax out-of-state income. Illinois and Iowa fall into this category. This means that if you have an employee who lives in Illinois but works in Iowa, you wouldn't deduct state withholding for that employee. You can find a complete list of reciprocity agreements here.
4. Deduct the FICA (Federal Insurance Contributions Act) payroll tax.
FICA payroll tax is made up of Social Security (OASDI) and Medicare tax. To calculate it, multiply the employee's gross pay for the pay period by 7.65%. Of this 7.65%, 6.2% is for Social Security and 1.45% is for Medicare.
Here is the calculation for the FICA tax deduction for the salaried employee who earned the $100 bonus above:
$1,446.15 x 0.0765 = $110.63
Here is the calculation for the hourly employee who worked 5 hours of overtime:
$337.50 x 0.0765 = $25.82
There are a few caveats to keep in mind when it comes to FICA. For example, each year, the Social Security Administration sets a maximum withholding based on cost-of-living expenses. Once an employee's annual gross pay reaches this threshold – which was $137,700 for 2020 – you can no longer withhold the Social Security portion of the FICA tax.
Additionally, in 2013, the IRS implemented the Additional Medicare Tax. Employers are now responsible for withholding an additional 0.9% from an employee's gross wages or salary if they reach a certain threshold. The applicable threshold depends on the employee's tax filing status. Currently, it's $250,000 for a married employee filing jointly, $125,000 for a married employee filing separately, $200,000 for an employee filing single, $200,000 for a head of household with a qualifying individual and $200,000 for a qualifying widow or widower with a dependent child.
5. Make other mandatory payroll deductions.
An employee may be subject to wage garnishments for back child-support payments, delinquent student loans, unpaid taxes and/or credit card debt. In these instances, you'll receive a notice from the federal or state government alerting you to the required wage garnishments. The notice will indicate the exact amount to withhold from each paycheck.
Payroll tools
Many companies offer payroll software that automates the process of paying salaried employees, hourly employees, and contractors or freelancers. Some of these vendors also provide free online tools that business owners can use to calculate gross and net pay. Here are a couple of options:
ADP Salary Paycheck Calculator
Offered by ADP through its Employer Resource Center, this tool performs gross-to-net calculations for employers and employees in all 50 U.S. states. There's also an accompanying Salary Paycheck Calculator Guide.
QuickBooks Paycheck Calculator
The QuickBooks Paycheck Calculator calculates net pay for salaried and hourly employees, factoring in bonuses, commissions and overtime worked.
Additionally, the IRS offers an Employer's Tax Guide that incorporates withholding information, instructions pertaining to withholdings and more.