Most employees don’t want to think about all those little deductions that make their take-home pay lower. As an employer, however, you should have a thorough understanding of everything that goes into (and out of) your employees’ paychecks. There are big financial implications for getting it all right, and employees are going to show up from time to time with questions.
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Follow these eight steps to figure out how to calculate an employee’s paycheck on your own:
1. Tally your employee’s gross wages from their employment agreement or time sheet
Most paychecks start with gross wages, which is the amount of money an employee has earned during the pay period. Gross wages include tips, commission, and overtime (if it applies to them).
For hourly employees, it’s the number of hours they worked times their pay rate—which should be adjusted if there’s overtime. If someone’s on salary, their gross earnings will be their annual salary divided by the number of pay periods each year.
2. Subtract elective pre-tax withholdings
If employees choose, some amounts may be withheld from their paychecks on a pre-tax basis, which lowers their taxable income — and your payroll taxes. That means you should take these deductions out of their gross pay before the calculations for income tax and other taxes are deducted.
Elective pre-tax withholdings include benefits like:
- Insurance premiums
- Health care deductions, like an FSA
- Retirement contributions like a 401(k) or 403(b)
- Child care assistance
3. Subtract employee-only taxes
There are certain paycheck deductions that only affect your employees (not you, the employer). You’ll withhold and set aside these funds, and then remit them to the government on behalf of your team as part of your payroll:
Federal income tax
You can determine how much federal income tax to deduct by looking at three factors:
- The employee’s taxable gross wages (after pre-tax withholdings are removed)
- Their marital status (indicated on their W-4 form)
- The number of allowances they have claimed (also on their W-4 form)
If you don’t have your employee’s W-4, assume they’re single and taking no allowances.
Once you know those three details, determine their federal income tax withholding amount by using the IRS Publication 15 (Circular E). Choose either the percentage method or the wage bracket method, and use the appropriate chart to help you through it.
Most states have an income tax as well. But like the weather, rates vary widely across state lines — from up to 13.3% in sunny California to zero percent in states like, well, sunny Florida. These are the state taxes and income tax brackets for 2019.
In addition to income taxes, State Disability Insurance (SDI) is also subtracted in states where an employee is expected to make a contribution (like California, Hawaii, New Jersey, New York, and Rhode Island).
Be sure to check the regulations where you live to see what is due. If your employees live in a bunch of different states, you’ll need to figure out each individually according to the state where they perform their work. Use this directory of state government websites to give you a head start.
City and local taxes
Some cities also take a piece out of employees’ paychecks.
These local taxes come in all sorts of flavors, too. Some are flat like the 1% rate in Birmingham, Alabama, while others are complex, like the bracketed system in Washington, DC. These rules vary depending on both the city where your business is based and the city where your employee lives. Check in with a local payroll expert to make sure you’re not missing anything.
4. Subtract other taxes (that both employees and employers must pay)
There are a few paycheck deductions that must be paid by both employees and employers. Only the employee’s share will show up on their pay stub, though.
Social Security tax
The Social Security Act of 1935 was enacted to give citizens a supplemental form of income for their retirement. Both the employer and employee contribute an amount equal to 6.2% of that employee’s gross income (up to $132,900), for a total of 12.4%.
After $132,900, no extra Social Security tax is withheld.
Every employee must pay 1.45% of their paycheck toward Medicare. Employers also contribute an additional 1.45%. Unlike Social Security there is no upper limit, so all gross income is taxed.
After your employee reaches a cumulative gross pay of $200,000, they’ll be subject to additional Medicare withholding at a 0.9% rate.
5. Subtract voluntary and involuntary deductions
In addition to taxes you withhold, there are other categories of deductions that can show up on a pay stub and lower your employee’s net pay.
Here are a few more items you may need to take out of your employee’s final paychecks:
Employees can have their wages withheld (or “garnished”) by court order to fulfill bad debts, alimony, or child support payments, and it’s the employer’s responsibility to withhold these funds. Because of the burden to employers, some court orders will include a small fee to be withheld from the employee to reimburse you for your administrative costs.
A garnishment is technically a legal action against an employer, so take care if you have employees whose wages are being garnished. There can be penalties if you don’t respond to a court order in a timely manner.
After-tax paycheck deductions
Then there are deductions that are taken after tax is deducted. These include things like union dues, charitable donations, and contributions to 529 college savings plans.
6. Add reimbursements back in
Paychecks get smaller and smaller with each deduction and tax withholding, but there is one place they can get bigger. That’s through any reimbursements for work-related expenses a teammate has incurred.
Did your employee do something like drive to visit a client, buy lunch for the team, or sign up for a conference with their own credit card? Then you might owe them some money.
Reimbursements are added in after taxes because they’re not really income an employee has earned. Remember that reimbursements are usually deductible business expenses for your company, so you’ll want to keep track of them for your own tax filings.
7. Do the math
When you’ve got all of the paycheck’s line items figured out, all you have to do is add (or subtract) them up using the following formula:
(Gross pay) – (Taxes) – (Deductions) + (Reimbursements) = Net pay
The number you’ll get at the end (the net pay) is what your employee will actually receive in their paycheck.
The bottom line? There’s a lot going on when you pay employees. There’s a reason it can take hours to get payroll right (and not everyone does — the IRS hit small businesses with $5 billion in penalties in 2017 alone).
Fortunately, you’re not on your own when it comes to explaining things to employees. This article can help them make sense of the wild world that is their pay stubs.