Understanding how to handle payroll for your small business can easily turn into a nightmarish quest. Different kinds of pay, deductions and labor laws all need to be considered and handled properly.
To stay on top of legal requirements and payroll rules, you just have to start tackling the essentials one by one. Grasping the difference between gross pay vs. net pay is probably the first one to conquer.
In short, gross pay refers to the total amount an employee earns before any deductions or taxes. In contrast, net pay is the amount an employee receives after all deductions, such as taxes and other benefits, are taken out.
Calculating net pay vs. gross pay accurately can help you avoid making payroll mistakes. In the sections below, you can find out more about these two types of pay and how to calculate them for your company’s payroll.
What Is the Difference Between Gross Pay and Net Pay?
Gross pay is an employee's total salary before any taxes and other withholdings are deducted from their paycheck, while net pay is the income that an employee would receive after all possible deductions have been made. This represents the actual total amount of money they can use, or their take-home pay.
If you’re an employer, make sure your team understands the difference between gross pay vs. net pay since it significantly affects how much they receive. For example, an employee with a gross salary of $50,000 per year may end up taking home significantly less than that once taxes, Social Security contributions, and other deductions are taken out of their paycheck.
When preparing payroll for your team, you would need to include both net and gross pay on the pay stubs. The gross pay usually appears first, followed by details about the various withholdings that apply for the employee. Afterwards, the net pay amount should also be included.
Calculating Gross Pay vs. Net Pay
The definitions of gross and net pay are easy to grasp. However, the payroll battle gets tough when it comes to calculating payments for different types of workers.
Employees who receive a fixed remuneration per year are called salaried employees. They are considered exempt employees under the U.S. Fair Labor Standards Act (FLSA).
Gross income signifies the total yearly amount that an employee earns. In order to calculate the gross amount for a weekly, biweekly or monthly term of a salaried worker, you can use the following formula:
Gross pay = annual gross salary / number of payroll periods
For example, if the annual gross pay of a team member is $33,000 and you want to calculate the monthly pay, you can divide $33,000 by 12 months. The result is $2,750. You can adjust the calculation to a weekly or bi-weekly payroll period, if you need to obtain even more granular information.
The calculation for the gross pay of an hourly worker is different than that of a salaried employee.
The formula is the following:
Gross pay = gross hourly rate x number of hours worked in a pay period
You can thus easily calculate the gross wage of an hourly worker according to the number of pay periods. The period can be a week, month, or even year, but in all cases, you must use the gross hourly wages that you have set when hiring the employee.
To get the calculation right, you also have to keep in mind the hours per week that the person has agreed to work. In many cases, it’s 40 hours per week, but hours can vary for part-time employees.
Let’s say that you pay the minimum wage - $12 per hour (gross) to one of the couriers working for your delivery company with less than 25 employees in California.
The person works 40 hours per week, so the standard full-time work week. You want to determine the employee’s gross wage for a month.
The calculation will be the following:
$12 x 40 hours x 52 weeks /12 months = $2,080
The gross pay of an hourly employee may also span other types of payments, such as overtime pay and bonuses. Keep in mind that the overtime pay rate is 1.5 times the regular hourly rate of a worker.
Formula for Calculating Net Pay
In order to calculate an employee’s net pay, you have to first determine the gross pay, following the formulas in the previous section.
Then, you can make the following subtraction:
Net pay = gross pay - all types of deductions
This formula also appears quite straightforward. The catch is that you need to determine all the various tax rates and other obligatory and voluntary deductions that apply to this particular person.
Getting your numbers right helps you dodge costly mistakes and potential legal troubles. For example, let’s say a small business owner uses the wrong tax rates when calculating an employee’s net pay. The employee ends up with a smaller paycheck than they were counting on, which is definitely no fun. Plus, the business owner might get slapped with a fine from the tax authority for underreporting taxes. Yikes!
This is where Hourly.io comes in handy. It automatically calculates the correct tax rates and deductions for each employee, ensuring accurate and compliant payroll management.
Basics about Payroll Deductions and Tax Withholdings
What types of deductions and withholdings do you have to keep in mind in order to calculate your payroll correctly, and more specifically - the net pay?
The main income tax withholdings from an employee’s paycheck include local, state and federal income taxes. All staff members have to fill out a W-4, the Employee’s Withholding Certificate. In it, they have to declare their tax deductions, with special consideration to the number of people in their family. You have to cross-check with the IRS tax charts in order to determine the deductions that apply. That’s how you will get the amount of payroll taxes that have to be withheld.
The other major obligatory withholdings for employees include Medicare tax (1.45%) and Social Security tax (6.2%), which is often referred to as FICA tax (7.65% altogether). You have to direct all tax deductions to the IRS and pay the rest of the sum to the employee.
In some cases, there may be additional deductions, called wage garnishments. They may include unpaid child support, student loans, taxes, and credit card loans, among others.
There are also voluntary deductions that you may need to take out from an employee’s gross pay to calculate their net pay. Some of the typical ones include health insurance premiums, retirement contributions, additional life insurance, donations to charities, and others.
Keep in mind that health benefits and retirement contributions are considered pre-tax deductions. They have to be subtracted before the tax withholdings are applied. Post-tax deductions include garnishments, for example, which have to be deducted after taxation.
Keep Your Payroll Records and Stay in Compliance
As a business owner, it's crucial to stay on top of payroll management. It might sound complicated and overwhelming at first, but you can do this!
All you need to do is make sure you have all the relevant documents and records you need stored in one place. By keeping accurate records like payroll registers, pay stubs, and payroll records, you’ll have everything you need to avoid legal penalties or other potential issues that could arise.