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 anyone who’s been running payroll for long also knows that employees are going to show up from time to time with questions.
To make sure you have all the answers, here’s a refresher on what might happen to a paycheck as you move from the gross pay your team earns to the net pay your employees ultimately see.
Start with gross wages
Most paychecks start with gross wages, which is the amount of money an employee has earned during the pay period. This is probably the easiest number to come up with. For hourly employees, it’s the number of hours they worked times their pay rate — which should be adjusted it 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.
That’s the big pie. Once you’ve got gross pay, the pie gets smaller as slices for taxes and other deductions are gobbled up until you get to net pay — the amount employees actually take home.
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 these deductions are taken out of gross pay before the calculations for income and other taxes are deducted. These include benefits like:
- Insurance premiums
- Health care deductions, like an FSA
- Retirement contributions like a 401(k) or 403(b)
- Child care assistance
Subtract employee-only taxes
There are certain paycheck deductions that only affect your employees. As an employer, you 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
The ultimate paycheck boogeyman, federal income tax rates slurp up 25 percent of the average American’s salary. Employers determine the rate of federal income tax deductions based on three factors:
- The employee’s taxable gross wages (after pre-tax withholdings are removed)
- Their marital status
- The number of allowances they have claimed on their W-4
These taxes are withheld by you and submitted to the IRS.
While this is the biggest piece that’s taken out of paychecks, some of it may come back to employees in the form of a tax refund check if they declare charitable, mortgage, or other tax write-offs on their personal tax filings.
Still, for most people, this line item is the one that hurts the most.
State income tax
Like the weather, tax rates vary widely across state lines; from 13 percent in sunny California to zero percent in states like, well, sunny Florida. These are the state taxes and income tax brackets for 2017.
City and local taxes
Some cities also take a piece out of employees’ paychecks. They come in all sorts of flavors too. Some are flat like the one percent 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 employees live. Check in with a local payroll expert to make sure you’re not missing anything.
In addition to these 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).
Subtract other taxes (that employers must pay, too)
There are a few paycheck deductions that must be paid by employers — usually in the form of a matching contribution. Only the employees’ share will show up on their pay stub, though.
The Social Security Act of 1935 was enacted to give citizens a supplement form of income for their retirement. Both the employer and employee contribute an amount equal to 6.2 percent of that employee’s gross income (up to $127,200 in 2017). Income above that amount is exempt.
Every employee must pay 1.45 percent of their paycheck toward Medicare. Employers also contribute an additional 1.45 percent. Unlike Social Security there is no upper limit, so all gross income is taxed. Additional Medicare Tax is withheld on wages that exceed $200,000 in a calendar year.
When we get to Paychecks 102, note that there are also some costs of employment you bear that your employees will rarely see, like the unemployment taxes you cover.
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 someone’s net pay. In addition to the pre-tax withholdings mentioned above, here are a few more items you may need to take out of your employees’ final paychecks:
Employees can have their wages withheld (or “garnished”) by court order to fulfill bad debts, alimony, or child support payments, and it is the responsibility of employers 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 which are withheld after tax is deducted. These include things like union dues, charitable donations, and contributions to 529 college savings plans.
Add reimbursements back in
Paychecks get smaller and smaller with each deduction, but there is one place it 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 owe them some money.
Reimbursements are added in after taxes are calculated since they’re not really income an employee has earned. And remember that reimbursements are usually deductible business expenses for your company. You’ll want to keep track of them for your own tax filings.
Do the math to get net pay
When you’ve got all of your paycheck’s line items figured out, all you have to do is add (or subtract) them up. The number you’ll get at the end is the net pay. This number is what an employee actually receives in their paycheck.
The bottom line? There’s a lot going on when you pay employees. There’s also a reason it can take hours to get payroll right (and not everyone does — the IRS hit small businesses with 6.8 million penalties in 2014 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.