Payroll Deductions From Gross Pay vs. Net Pay
Managing payroll is an important responsibility for a small business owner. It requires attention to detail. You need to stay on top of how much to deduct from each employee's paycheck because every worker's tax circumstance is different. You also have to file employment taxes on a timely basis to avoid penalties and fines. Many small businesses use software that automatically calculates payroll deductions. However, it is always good to know how to calculate the deductions.
Gross pay is simply your employee's wages before any deductions. If you pay an employee on an hourly basis, the gross pay is the amount of hours she worked multiplied by the hourly rate. If you pay your employee a salary, the gross pay per period is the annual salary divided by the number of times you pay her in the year. For example, if the employee earns an annual salary of $45,000 and you pay her bi-weekly or every two weeks, her gross pay per pay period is $1,730.77 ($45,000 divided by 26 weeks).
An employee's tax-filing status depends on how she filled out her Employee Withholding Allowance Certificate, called a W-4. For instance, the income tax withholding is different for an employee who files as a single taxpayer with one allowance for herself compared with a married employee with several allowances. The more allowances an employee has, the less income tax you withhold from her paycheck, meaning she gets to keep more money for herself. To calculate the income-tax deduction, refer to the Internal Revenue Service's Publication 15. You have a choice of using the "Wage Bracket Method" for employees claiming more than 10 withholding allowances, the "Percentage Method" or an "Alternative Method."
The IRS publishes tables for the percentage method based on frequency of pay. For example, if you are on biweekly payroll schedule, go to the "Biweekly Payroll Period" on the IRS website to look up income withholding for a single employee claiming one withholding allowance. In 2012, the biweekly withholding for one allowance is $146.15. To obtain the amount subject to withholding, subtract the allowance amount from the gross pay. For example, if a single employee claiming one allowance earned between $1,778 in the biweekly period, the amount subject to withholding is tax withholding is $1,631.85 ($1,778 - $146.15). Go to the percentage method table to look up the appropriate withholding amount. In this case, you would withhold $187.15 plus 25 percent of the excess over $1,442, or $234.61 ($187.15 + (25 percent x ($1,631.85 - $1,442)).
The Federal Insurance Contributions Act requires that employees pay Social Security and Medicare taxes. In 2012, the FICA is 13.3 percent, of which the employer pays half and the employee pays the other half. The percentage is 5.2 percent for Social Security tax and 1.45 percent for Medicare taxes that you must apply to each employee's pay. For example, for the employee who earned $1,778 during the pay period will get 6.65 percent taken out of her paycheck for FICA -- or $92.46 for Social Security (5.2 percent x $1,778) and $25.78 for Medicare (1.45 percent x $1,778). In 2012, the maximum wage limit subject to Social Security tax is $110,000. However, you still have to deduct Medicare tax.
There are other deductions that you might need to make before arriving at an employee's net pay. These include health and life insurance premiums and 401(k) retirement plan contributions. Some of these deductions may be on a pre-tax or after-tax basis. It is not uncommon for 401(k) deduction to be on a pre-tax basis, which means that you have subtract the 401(k) contribution before you take out federal income taxes.
Net pay is the final result after subtracting federal income, FICA and other deductions. You also have to deduct any state and local taxes before arriving at net pay. Using the previous example, the payroll deductions are $234.61 for federal income taxes and $118.24 for FICA taxes for a total deduction of $352.85. This means that the employee walks away with a net pay of $1,425.15 ($1,778 - $352.85) assuming that there are no other payroll deductions.