If you’re a small business owner grappling with the complexities of calculating payroll, you’re not alone. With a myriad of tasks to handle, from paying employees to all the work you put in to grow your business, dealing with payroll calculations and the IRS tax code may feel overwhelming and time-consuming.
Word of relief is that, although these responsibilities appear daunting, once you understand the necessary tax filings and learn the calculation process, it becomes more manageable. Getting started is commonly the worst part of many things, so to help you navigate this process, we’ve prepared a comprehensive step-by-step guide on calculating payroll and payroll taxes.
Here, you can find comprehensive answers to most, if not all of your payroll questions. And if you encounter any challenges or prefer to offload the responsibility of payroll taxes, our convenient payroll software solutions and services are available to handle the heavy lifting for you. But don’t take our word for it. You can explore PrimePay’s client reviews to gain insights from businesses that have partnered with us.
Without further ado, let’s dive right in.
In order to begin calculating payroll, you’ll need to have your employees complete the following new employee forms:
- Form W-4: Also known as Employee’s Withholding Certificate, this tax form is used by employees in the United States (U.S.) to determine their income tax withholding. In other words, this form is used to inform their employers about the amount of federal income tax to withhold from their paychecks.
- State W-4 (as applicable): Also known as the Employee’s Withholding Allowance Certificate for State Taxes, this tax form is used by employees in the U.S. to inform their employers about the amount of state income tax to withhold from their paychecks.
- Direct Deposit Authorization Form: If you’re planning to use direct deposit to pay your employees, this form allows individuals to authorize their employer or other payers to deposit their payments directly into their bank account.
- Employers can require direct deposit in the following states:
- North Carolina
- North Dakota
- South Carolina
- South Dakota
- Employers can require direct deposit in the following states:
- Form I-9: Also known as Employment Eligibility Verification, Form I-9 is a document used in the U.S. to verify the identity and employment authorization of individuals hired for employment. The U.S. Citizenship and Immigration Services (USCIS) requires employers to complete Form I-9 for each employee hired, including citizens and noncitizens.
To stay compliant, it’s imperative that you get familiar with employment tax due dates associated with payroll-related forms and reporting. The bottom line is, staying on top of employment tax due dates is just as imperative as paying your employees on time. So study up on the requirements before you get started to dive right in with confidence.
Resources from the Internal Revenue Service (IRS):
Step 1: Calculate the Total Amount of Time Worked During the Pay Period
Now that we’ve got some of the startup forms covered, and your employees set up, you’re ready to run payroll and begin calculations (that is if your business is set up, too, of course).
Part of getting payroll set up is determining the total time employees worked for the period. But please note: this will be different for salaried employees vs. hourly employees.
Total Amount of Time Worked for Salaried Employees
For salaried employees, you’ll need to calculate their total amount of time worked based on their annual salary. Divide their annual salary by the number of pay periods in a year (usually 26 or 52), and then divide that number by the number of work hours in a pay period. This will give you the total amount of time worked for the pay period.
Related: PrimePay’s Salary Paycheck Calculator
Total Amount of Time Worked for Hourly Employees
For hourly employees, you’ll need to calculate their total amount of time worked based on their hours worked for the pay period. This can be done manually, or by using a tool like PrimePay’s Hourly Paycheck Calculator.
If you prefer to do things manually, here are the steps to effectively calculate the total amount of time worked for hourly employees:
- Gather Timekeeping Records: Collect all the timekeeping records for the pay period. This may include timesheets, time clock data, or any other method used to track employee hours.
- Review Work Hours: Thoroughly review the timekeeping records for each employee. Ensure that all hours are accurately recorded, taking into account regular working hours, overtime, breaks, and any other applicable time classifications.
- Calculate Regular Hours: Determine the regular hours worked by each employee. Regular hours typically refer to the standard working hours agreed upon in employment contracts or company policies.
- Identify Overtime Hours: Identify any hours worked by employees that exceed the predetermined threshold for overtime. This threshold is usually based on local labor laws or employment agreements.
- Calculate Overtime Hours: Calculate the total overtime hours for each employee. Overtime hours are typically compensated at a higher rate than regular hours, so accurate calculation is crucial for fair and compliant payroll.
- Account for Time Off: Take into consideration any approved time off, such as vacation days, sick leave, or holidays, and adjust the total hours worked accordingly. Ensure that the appropriate deductions or accruals are applied based on your company’s time-off policies.
- Verify Accuracy: Double-check all calculations to ensure accuracy. Mistakes in calculating hours worked can result in incorrect wages and potential compliance issues. A thorough review helps minimize errors and ensures employees are compensated fairly.
Step 2: Calculate the Gross Pay Before Any Deductions & Taxes
Gross wages refer to an employee’s compensation before taxes and deductions are taken out. It’s important to note that the calculations for gross pay differ between salaried vs. hourly employees.
To calculate gross pay for hourly workers, take the employee’s hourly wage and multiply it by the number of hours worked. This gives you the employee’s gross pay for the pay period. Keep the steps outlined above for calculating total time worked for hourly workers in mind when calculating gross pay.
Gross pay for salaried employees, who are exempt from overtime rules, typically remains consistent from one pay period to another. To calculate their gross pay per pay period, divide their annual salary by the number of pay periods in a year. For instance, if a manager earns an annual salary of $80,000 and receives paychecks twice a month, their gross pay for each pay period amounts to $3333.335 ($80,000 divided by 12 months, then divided by 2 monthly pay periods). Do note that biweekly (every other week) pay frequency differs from semi-monthly (twice monthly). Biweekly pay frequency has 26 pay periods per year, whereas semi-monthly has 24 pay periods annually. This can affect your gross pay calculation.
For both hourly and salaried employees, you should also subtract any pre-tax benefits the employee receives to calculate gross pay. This might include items like health insurance or 401(k) contributions.
Related: PrimePay’s Gross-Up Calculator
Gross Pay Formula – Hourly
If an employee works 40 hours per week and earns $15 per hour, their gross pay would be calculated as follows:
40 hours x $15/hour = $600
Gross Pay Formula – Exempt Salaried
For exempt salaried employees, you’ll need to divide their annual salary by the number of pay periods in a year. For example, if an employee’s annual salary is $50,000 and they are paid bi-weekly, their gross pay for the pay period would be:
$50,000 / 26 pay periods = $1,923.08
Gross Pay Formula – Nonexempt Salaried
For nonexempt salaried employees, you’ll need to calculate their hourly rate first. Divide their annual salary by the number of work hours in a year (usually 2080). Then, multiply that number by the number of hours worked in the pay period. For example, if an employee’s annual salary is $50,000, their hourly rate would be calculated as follows:
$50,000 ÷ 2,080 (number of work hours in a year) = $24.04 (hourly rate)
If the employee works 80 hours in the pay period, their gross pay would be:
$24.04 x 80 = $1,923.20 (gross pay)
It’s important to note that nonexempt salaried employees are entitled to overtime pay for any hours worked over 40 in a workweek. The overtime rate is typically calculated as time and a half (1.5 times their regular hourly rate).
Step 3: Subtract Deductions & Taxes From Gross Pay
In order to calculate employees’ final net pay, you’ll need to subtract all of the deductions and taxes from their gross pay. The result is the employee’s take-home pay.
It’s important to make sure all of the calculations are accurate and that you are withholding the correct amount of taxes. Errors in payroll calculation can result in costly penalties and back taxes.
How to Calculate Employee’s Tax Withholding Amount
Calculating an employee’s tax withholding involves following these steps:
- Obtain the employee’s completed Form W-4: Ensure that the employee has submitted a properly filled-out Form W-4, the Employee’s Withholding Certificate. This form provides important information such as the employee’s filing status, number of allowances, and any additional withholding instructions.
- Note: The federal Form W-4 underwent a significant overhaul by the IRS in 2020 (see W-4 FAQs). One key change that sets apart the 2020 W-4 form from its 2019 and earlier versions is the removal of withholding allowances. This elimination of withholding allowances was unexpected for both employers and employees. Withholding allowances have been relied upon by employers for years to calculate income tax withholding.
- Determine the employee’s filing status: Based on the information provided on the Form W-4, determine the employee’s filing status, which could be single, married filing jointly, married filing separately, or head of household.
- Account for additional withholding requests: Check if the employee has requested any additional amounts to be withheld from their paycheck, such as for extra income or to cover specific tax obligations.
- Refer to state withholding tables: When it comes to calculating and withholding state income taxes from your employees’ paychecks, it is crucial to refer to state withholding tables. State withholding tables are specific to each state and provide guidelines on how much state income tax should be withheld from employee wages based on their income, filing status, and other relevant factors.
- Calculate the tax withholding: Apply the information from Form W-4 and the appropriate withholding tables to calculate the amount of tax to withhold from the employee’s wages for each pay period.
- Deduct any pre-tax contributions: If the employee participates in pre-tax benefit programs, such as a retirement plan or health insurance, subtract the corresponding amounts from the employee’s wages before calculating the tax withholding.
- Consider state and local taxes: Determine if state and local income taxes apply. Check the respective tax authorities’ guidelines to calculate the appropriate tax withholding for those jurisdictions.
- Update withholding as necessary: Regularly review and update the employee’s withholding based on any changes in their circumstances or tax laws. Employees should submit a new Form W-4 whenever necessary, such as when they experience significant life events (e.g., marriage, divorce, birth of a child) or changes in their financial situation.
- Document and retain records: Keep accurate records of the employee’s tax withholding calculations and related documentation for future reference and compliance purposes.
Our Wage & Tax portal includes tax information for each state, including each state’s withholding tables.
Step 4: Include Expense Reimbursements
When employees incur business-related expenses using their own funds, it is important to reimburse them accordingly. Employers have the option to handle reimbursements separately or include them with regular payroll.
Keep in mind that expense reimbursements are separate from gross wages and should not be subject to tax withholding. Reimbursed expenses should be paid in full and added to the employee’s net pay as part of the final calculation.
Step 5: Add it all up
After completing the necessary calculations for gross pay, tax withholdings, deductions, and expense reimbursements, you can determine the final paycheck amount by following these steps:
- Begin with the gross pay.
- Subtract the employee’s tax withholdings.
- Subtract any applicable deductions.
- Add any approved expense reimbursements.
By going through these calculations, you will have an accurate understanding of the exact amount to provide to your employee on payday.
Quick Tip: Payroll Records and Reporting Requirements
Small business owners are required to maintain accurate payroll records for each employee. This includes the amount of pay, taxes withheld, and any benefits they receive. You’ll also need to report employee taxes to the appropriate agencies and file quarterly and annual tax returns.
Make sure you keep accurate records and meet all reporting requirements to avoid legal issues and penalties.
Frequently Asked Questions (FAQs) About Calculating Payroll Taxes
Now that we’ve covered the steps, let’s address some FAQs. Taxes differ in responsibility for both employers and employees. We’ll break down the basics for you here.
1. What is payroll tax?
If your business has employees, you’re required to withhold payroll taxes from employees’ paychecks and pay any applicable federal, state, and local taxes.
Federal taxes include the following:
- Federal Insurance Contributions Act (FICA taxes) – The employer pays half, and the employee pays half.
- Federal Unemployment Tax Act (FUTA) – Paid by the employer.
- Federal income tax – Paid by the employee.
On the state level, under the State Unemployment Tax Act (SUTA), employers are obligated to pay a payroll tax that directly contributes to their respective state’s unemployment fund. For some states though, such as Alaska, New Jersey, and Pennsylvania, State Unemployment Insurance (SUI) taxes are paid by both the employer and employee.
Always check your local regulations as there are certain payroll taxes that are as specific as which municipality or township you operate within.
2. Which workers are taxable?
Before you even get to all these calculations, you must determine the types of workers you employ. That might seem like an obvious step, but it could be easy to overlook the tax responsibilities of an employee versus an independent contractor. Employees are subject to payroll taxes while independent contractors are responsible for paying their own taxes.
The IRS has a comprehensive guide for determining the difference, but here’s a quick set of questions to ask that can help.
- Does the company control or have the right to control what the worker does and how he or she does the job?
- Are the business aspects of the job controlled by the payer? (Ex. Are expenses reimbursed?)
- Are there written contracts or employee-type benefits? (Ex. Vacation pay or insurance). Will the relationship continue and is the work a key aspect of the business?
We have more information on classifying your employees if you want to dive a bit deeper.
3. What are taxable wages?
At its most basic level, taxable wages are compensation for services performed. This would include salary, bonuses, or gifts. Other forms of compensation that you might provide such as business expense reimbursement do not qualify as taxable wages. For the expenses to be nontaxable, they must be necessary, reasonable, and business-related, and employees have to verify them through receipts or expense reports.
Do you offer benefits that are funded through payroll deductions? Some are made on a pre-tax basis, thus reducing the amount of pay that is subject to tax.
Examples of these types of deductions that need to be factored in are:
- Contributions to certain types of retirement plans.
- If you are a nonprofit, your employees may participate in a 403(b) plan.
- A health flexible spending account (FSA) or a health savings account (HSA).
4. Withholding – What are the responsibilities of both the employee & employer?
Upon hiring, each employee is required to fill out a Form W-4. The amount of federal tax withheld is based on an employee’s W-4. As a reminder, federal withholding tax is paid only by the employee.
FICA is comprised of Social Security and Medicare taxes, paid in equal amounts by both the employer and employee.
When it comes to calculating a paycheck, let’s say John gets paid $580 bi-weekly. He participates in his company’s 401(k) retirement plan at a rate of 6%. John is also enrolled in his company’s cafeteria plan; his pre-tax medical deduction is $10 per paycheck.
Here’s how to calculate a paycheck that contains pre-tax deductions:
- Compute 401(k) contribution. (John’s example: $580 x 0.06 = $34.8)
- Calculate the amount of pay subject to federal income tax by subtracting both the 401(k) contributions plus cafeteria plan deductions. (John’s example: $580 – ($34.8 + $10) = $535.2)
- To calculate the amount of pay subject to Social Security and Medicare taxes, you must understand that 401(k) plans are not exempt from Social Security and Medicare taxes. To calculate, re-add in the 401(k) contribution amount. (John’s example: $535.2 + $34.8 = $570)
5. What are the current tax rates?
In order to calculate your payroll tax, you must know the current rates. Keep in mind that the information the employee puts on their Form W-4 would impact federal withholding.
In addition to federal withholding, the Social Security tax rate for employees is 6.2 percent. The Social Security taxable wage base is $160,200. The Medicare tax rate is 1.45 percent of the employee’s gross pay.
The FUTA tax rate is 6.0 percent of the first $7,000 you pay in wages to an employee. This tax is paid by the employer. You are required to pay this tax if either of the following applies:
- You pay wages totaling at least $1,500 per quarter.
- You have at least one employee on any day for 20 weeks in a calendar year (regardless of if these weeks are consecutive).
For state-withholding purposes, each state varies. Check our Quick Wage & Tax Guide to understand your state’s specific tax rates. We update this resource every year.
What other options do I have?
This breakdown only scratches the surface of how to calculate payroll taxes. As you may already tell, it can be very complicated. If you would like to do some of your own calculations, PrimePay’s calculators can help, including options such as salary paycheck, FICA tip credit, gross-up calculators, and much more. These calculators can benefit both you and your employees.
Calculating payroll by hand can be a daunting task, especially for those without a background in accounting. That’s why there are experts in the field that can take care of this responsibility for you.
If you’re a small business owner and find payroll calculations to be overwhelming, you may want to consider outsourcing your payroll to a third-party provider. Outsourcing can save you time and help you avoid costly mistakes. A professional payroll service can handle everything from calculating paychecks to reporting and filing taxes.
Using Payroll Software
Investing in payroll software can also make the payroll process much easier. Payroll software can help streamline payroll calculations, ensure accuracy, and simplify the tax reporting process. Many payroll software programs can also automate tax calculations and deductions, saving you time and preventing errors.
Choosing a Payroll System
Regardless of the system you choose, it is crucial to make sure you avoid the common errors made when processing payroll in-house, and that your calculations are accurate and comply with state and federal tax laws. Incorrect payroll calculations can lead to penalties, back taxes, and lawsuits. By taking the time to learn how to calculate payroll or investing in reliable payroll software, you can avoid payroll headaches and focus on growing your business.
Calculating payroll can be complex and time-consuming, but it’s critical to running a small business. By following these steps or using reliable payroll software, small business owners can accurately calculate payroll and avoid costly errors. Make sure you keep accurate records, meet all reporting requirements, and stay up to date with state and federal tax laws. By doing so, you can focus on growing your business and achieving your goals.
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