Editor’s note: If you need to calculate payroll costs for the Paycheck Protection Program during COVID-19, refer to the U.S. Treasury Department’s guidelines, beginning on page 8 of the Interim Final Rule.
Paying your employees accurately and on time is about more than being a good employer: It’s the law. Because your payroll expense is probably the largest expense you have, keeping track of it is vitally important. Below we’ll review how to calculate payroll, including gross wages, payroll taxes, and benefits. This will give you the tools you need to manage this large expense accurately and efficiently.
What is payroll?
Payroll is a catch-all term encompassing two distinct aspects of your financial responsibilities as an employer.
The first is the sum total of all expenditures paid to your employees. For most employers, it can be broken down into three categories:
- Remuneration: This is the agreed-upon wage between employer and employee.
- Benefits: This will be the portion of any benefits paid by the employer.
- Social Security, Medicare, and unemployment taxes: Taxes can be federal, state or local, depending on the jurisdiction. For payroll, this likely only includes an employee’s Social Security and Medicare contributions.
The second element that goes into payroll is deducting the proper amount of an employee’s wages to satisfy his or her annual income tax. This is known from a small business owner’s perspective as an employee’s income tax deduction.
Let’s take a look at expenditures first.
Expenditures, which are your standard expenses as stated above, can be broken down into several categories. Ultimately these little pieces add up to the gross pay your employee or employees receive. Still, it’s easier to understand expenditures if you break it into these four separate categories.
Remuneration, also known as compensation, is how your employees are paid. It varies based on employers, business types, and fee structures. Generally, the common wage structures are annual salary or hourly employees. There is also the chance of a base salary, plus commission, particularly in sales.
Bonuses — whether given annually as part of a hiring package or just for recognition of work — should also be considered part of an employee’s remuneration. Basically, think of their remuneration as their total take-home pay: hourly rate or salary, commission, bonuses, and any other financial boons they receive.
Remuneration is the basis on which your employees — and by extension, your business — will be taxed, so being accurate and extra attentive to detail here is the key to properly withholding taxes from employee checks. It’s key to filing taxes as well.
2. Benefits paid by the employer
As an employer, you can choose to offer your employees benefits. Many employers also pay a portion of these expenses on behalf of the employee as part of their benefits package. You can also offer the option to deduct the cost of the benefits from the employee’s gross wages.
Typical benefits include:
- Healthcare, dental, and vision insurance
- Life insurance
Typical benefits with voluntary deductions include:
- Retirement contributions (matching the percentage for a 401(k) or 403(b))
- Child daycare
- Flexible spending accounts
- Healthcare spending accounts
The above benefits generally require the employee to contribute a certain percentage from his or her pre-tax income to pay for expenses throughout the year. These deductions do not normally require a contribution from an employer (with the exception of retirement accounts), but they do require that an employer keeps track of these deductions and calculates them correctly.
Additionally, if you offer your employees paid vacation or sick days, you’ll need to have a way of factoring in these days as well. Most paid time off is paid at the same rate as a day of work, so the most important thing is to make sure you’re keeping track of the number of hours an employee is taking as paid time off to ensure that he or she isn’t abusing your policy.
3. Social security, Medicare, and federal unemployment taxes
This category encompasses federal, state, and local taxes (if applicable) that both an employer and his or her employees are required to pay. All employees and employers are responsible for making Social Security and Medicare contributions. Employers are solely responsible for paying federal unemployment tax payments.
For tax year 2019, the federal tax rates are as follows:
- Social Security: 6.2% of an employee’s gross wages, up to $132,900 for each employee
- Medicare: 1.45% of gross wages with no earning limit
- Federal Unemployment Tax: 6% of gross wages, up to $7,000 for each employee
Let’s start with Social Security and Medicare. Your employees’ wages determine the final amount you, as a business, will pay. Start by deducting the applicable percentages — 6.2% for Social Security and 1.45% for Medicare — from the employee’s gross wages. Do this for every employee you have.
After you have a sum total of your employees’ contributions, you must match that contribution. Once all payments are pooled, the business is responsible for making this total payment on behalf of the company and its employees.
For example, let’s say that you own a business that just hired its first employee, named Frank. Frank is paid bi-weekly, works 40 hours per week and receives an hourly wage of $14. Based on two weeks of wages at $1,120 ($14 per hour x 80 hours), here is how you calculate the total Social Security and Medicare portion of payroll for Frank and the business:
- The Social Security tax deducted from Frank’s wages: $1,120 x 0.062 = $69.44
- Your matching Social Security tax amount: $69.44
- The Medicare tax deducted from Frank’s wages: $1,120 x 0.0145 = $16.24
- Your matching Medicare tax amount: $16.24
- Total = $171.36
The total Social Security and Medicare tax due for this pay period is $171.36, consisting of contributions from both Frank and your business. Social Security and Medicare tax payments are due either semi-weekly or monthly, depending on your small business’s payment circumstances. They’re reported quarterly using IRS Form 941. Don’t be late with payments, as you can be slapped with a penalty of up to 15% of the missed amount.
There are some types of wages, fringe benefits, and other remuneration that you don’t have to pay Social Security or Medicare taxes on. IRS Publication 15-B can help you calculate these taxes correctly. Also, section 15 of IRS Publication 15 has a helpful table summarizing different types of employee pay.
Now, consider Frank when it comes to paying the Federal Unemployment Tax. Let’s say that he was hired only two weeks ago and that his total gross income is $1,120. Since his gross income is less than the maximum taxable amount ($7,000), you would multiply $1,120 by 6%, or 0.06, which comes to $67.20. This is a sum that the business itself must pay. It is not deducted from Frank’s earnings.
FUTA payments in excess of $500 in a given fiscal quarter are due one month after the close of that quarter. If your FUTA bill is less than $500, you can carry it over to the next quarter. FUTA payments must be reported annually on IRS Form 940.
Like FUTA, state unemployment tax, or SUTA, is also paid by employers. Rates and wage bases vary by state. Most states also require employers to pay into a workers’ compensation insurance fund. Rates for workers’ compensation insurance are determined by the region of the country, the industry, and the employer’s own history of workplace accidents.
4. Income tax deductions
As an employer, your responsibility is to correctly calculate the amount of gross wages that are eligible for federal and state taxes, as well as the subsequent tax amount. Once you’ve deducted that amount, it’s your responsibility to pass that money along to the appropriate government agency.
It’s also worth noting that these same types of taxes are often collected by state governments. Tax rates vary depending on the state, and some states don’t collect certain types. For example, Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming have no state income tax. New Hampshire and Tennessee don’t collect income taxes, but do tax residents’ dividend and interest income.
As an employer, you need to be aware of your state’s tax rate (if any) so you can correctly deduct it from your employees’ gross wages
Calculating federal (and state) income tax starts with counting your employee’s withholding allowances, which are reported by the employee on Form W-4. Allowances exempt a portion of an employee’s yearly salary from withholding. Most employees claim 0 or 1 allowances.
For an employee that claims zero allowances, this means that his or her employer will withhold more federal income tax from his or her paycheck, which will be reflected on the employee’s paystub. Some people prefer claiming no allowances, as doing so generally results in receiving a larger tax refund in the coming year.
Once allowances are factored in, federal income tax withholdings are calculated using various methods — with the most popular methods listed in IRS Publication 15. Withheld federal taxes are generally paid at the same time that you make Social Security and Medicare payments, and are likewise reported using IRS Form 941.
State income taxes are usually withheld in the same manner, and some states even offer their own W-4 equivalent. You should check with your state’s labor or employment office for guidelines on payment amounts and frequencies.
How to calculate payroll
Unless you’re an accounting wizard, you’ll probably need help calculating your payroll, paying your employees, and keeping all of your required tax payments straight. There are a few ways to go about this:
- Calculate it on your own
- Hire an accountant or payroll specialist
- Automate the payroll process using a full-service payroll software or online payroll solution, such as QuickBooks Payroll.
Most payroll services offer a trimmed-down solution for small business owners who may not need as many features as larger companies. There are also free online tools, such as Intuit’s Paycheck Calculator, which can calculate an employee’s paycheck with just a few pieces of information. If you only have one or two employees, this solution might be all you need.
Perfecting payroll every payday
As illustrated, payroll is not a simple one-time calculation and has many intricacies that can be hard to keep straight for small business owners who are juggling many other responsibilities. If you choose to manage your payroll yourself, make sure to diligently track these different charges and find an easy solution that works for you.
Otherwise, don’t be afraid to ask for help so that you can keep your most important asset — your employees — compensated and happy.
For more information on small business employment, read our article on all the costs that go into paying an employee.