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, taxes and benefits. This should 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 paid by the employer.
- Social Security, Medicare and Unemployment Taxes: Taxes can be federal, state or local, depending on jurisdiction. For payroll, this likely only includes an employee’s Social Security and Medicare contributions.
The second is deducting the proper amount of an employee’s wages to satisfy his or her annual income tax, known from a small business owner’s perspective as an employee’s income tax deduction.
Let’s take a look at expenditures first.
How employees are paid varies based on employers, business types and fee structures. Generally, the common wage structures are hourly and salaried. Particularly in sales, there is also the chance of a base salary plus commission or a straight commission structure. 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.
Remuneration is the basis on which your employees—and by extension, your business—will be taxed.
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 for the employee as part of their benefits package. You can also just offer the option of deducting the cost of the benefits from the employee’s gross wages.
Typical benefits that are offered include:
- Health/Dental/Vision Insurance
- Life Insurance
Typical benefits with voluntary deductions that are offered include:
- Retirement Contributions (Matching percentage for a 401(k) or 403(b))
- Child Day Care
- Flexible Spending Account
- Healthcare Spending Account
The above benefits generally require the employee to contribute a certain percentage amount 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 for factoring 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 make sure you’re keeping track of how much time off or sick time an employee is taking to make sure he or she isn’t abusing your policy.
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 2017, the federal tax rates are as follows:
- Social Security: 6.2% of an employee’s gross wages, up to $118,500 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% and 1.45% for Social Security and Medicare, respectively—from the employee’s gross wages. Do this for every employee you have.
Once 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 business 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’ worth 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:
- Frank’s wages are deducted by the Social Security Tax: $69.44 ($1,120 x 0.062)
- Your Matching Social Security Tax Amount: $69.44
- Frank’s Medicare Tax Amount: $16.24 ($1,120 x 0.0145)
- Your Matching Medicare Tax Amount: $16.24
- TOTAL = $171.36
The total federal tax amount due for this pay period is $171.36, comprised of contributions from both Frank and your business. Social Security and Medicare tax payments are due either semi-weekly or monthly (PDF), depending on your small business’ payment circumstances. They are reported quarterly using IRS Form 941 (PDF). Don’t be late with payments, as you can be slapped with a penalty of up to 15% of the missed amount.
Now, consider Frank when it comes to paying the federal unemployment tax (FUTA). 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 following 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 (PDF).
These same types of taxes are often collected by state governments. Tax rates vary depending on state, and some states don’t even 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.
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 that amount has been deducted, it is then your responsibility to pass that money along to the appropriate government agency.
Calculating federal 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. In tax year 2014, each allowance exempted $3,950 of 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. 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 during the same time 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 are 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 or on your own.
- Hire an accountant or payroll specialist.
- Automate the process using a full-service 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.
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 keep track of 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.