Payroll Basics

When it’s time to pay an employee, the employer calculates the gross* pay check amount. If the employee is paid on an hourly basis, the gross amount is calculated as number of hours worked times rate of pay. If overtime is paid, the calculation is the number of overtime hours worked multiplied by one and one half the rate of pay. Salaried employees can either be paid a flat salary every pay period regardless of how many hours they worked, or they may be paid overtime pay under certain circumstances.

After gross wages are calculated, taxes are deducted from the employee’s check. Some taxes are calculated as a percentage of gross wages, others are based on marital status and number of exemptions (as indicated on Form W-4) as well as other factors. These taxes are divided into two different categories: federal taxes (Social Security, Medicare and federal withholding) and state taxes (state withholding, state disability insurance, local taxes, state unemployment) when applicable.

There may also be other deductions that affect the employee’s check: health insurance, 401(k), uniforms, loans, etc. In addition, the worker may be reimbursed for expenses incurred on behalf of the company: mileage, general expenses, lodging, etc. Deductions reduce net (or take home) pay, while reimbursements increase net pay. Below is a sample of what a pay stub might look like:

The employer must also contribute payroll taxes for each employee that is paid. Employer taxes include Social Security, Medicare, federal unemployment, and state unemployment. Employers pay these taxes directly and employer tax contributions are not listed on pay stubs.

FICA – Employee and Employer Tax

FICA is composed of two taxes: Social Security and Medicare.

Social Security

Social Security is calculated by multiplying an employee’s taxable compensation x 4.2%.* For example, if an employee’s taxable compensation is $500 this week:

$500.00 x 4.2% = $21.00 (this amount would be deducted from the pay check)

There is a wage base limit for Social Security. For 2012, this tax is calculated only on the first $110,100 earned.

As mentioned in the previous Payroll 101 entry, the employer also pays this tax. They pay it at the “standard” rate* of 6.2% and are subject to the same wage base limit ($110,100 for 2012).

The total amount sent to the IRS for Social Security tax will be 10.4% of taxable compensation (4.2% is the employee share, and 6.2% is the employer share, for a total of 10.4%) through February 29, 2012. A specific formula is used when calculating the employer share of Social Security.

$500.00 x 10.4% = $52.00 (the total amount due for SS tax)

*The employee SS tax rate has been reduced to 4.2% through February 29, 2012. As of March 1, 2012, it is scheduled to return to a standard rate of 6.2%.

Medicare

Medicare is calculated by multiplying an employee’s taxable compensation x 1.45%. For example, if an employee’s taxable compensation is $500 this week:

$500.00 x 1.45% = $7.25 (this amount would be deducted from the paycheck)

There is no wage base limit for Medicare.

This is a tax that also requires an employer contribution. Employers pay it at the same rate as the employee (1.45%). If the Medicare tax for the employee portion of the tax is $7.25, the employer’s Medicare tax amount is also $7.25.

The total amount sent to the IRS for Medicare tax is 2.9% of taxable compensation (1.45% employee share plus 1.45% employer share is a total of 2.9%). A specific formula is used when calculating the employer share of Medicare.

$500.00 x 2.9% = $14.50 (the total amount of Medicate tax to be paid)

Federal Income Tax – Employee Only Tax

This tax (also known as Federal Withholding Tax, FWT, or FIT) is calculated using an IRS formula which considers an employee’s marital status, number of exemptions, pay frequency, and taxable compensation. There are several IRS-approved methods of calculating this tax; we will use the Percentage Method in this program.

FUTA (federal unemployment tax) – Employer Only Tax

Federal unemployment taxes are paid by the employer only. The Federal Unemployment Tax Act (FUTA) rate is currently set at 6.0%. Employers who pay their state unemployment tax on time receive an offset federal unemployment tax credit of 5.4% resulting in a net FUTA rate of 0.6%.

FUTA tax is calculated by multiplying an employee’s taxable compensation x .6%. For example, if the employee’s taxable compensation is $500 this week, the employer would pay:

$500 x .6% = $3.00

There is a wage base limit for FUTA. For 2012, this tax is calculated only on the first $7,000 earned. The wage base limit has not been changed since 1983.

State Income Tax – Employee Only Tax

This tax (also known as State Withholding Tax, SWT, SIT, or PIT) is typically calculated based on the same parameters as federal income tax. However, there are some states that may calculate income tax as a flat percentage of taxable compensation. There are nine states that do not have a provision for state income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Other State Taxes – Employee and/or Employer Taxes

Other state taxes that employees may be subject to are disability insurance, state unemployment, and local taxes. These taxes may also require an employer contribution.

Below is a chart which describes each tax. Please note: state taxes may be employer, employee, or both. Calculations vary from state to state.

Federal vs. State Taxes

Common terminology that might be used is below:

Federal taxes are any taxes that are deposited with the IRS.

• Federal Income Tax (FIT or FWT)
• Social Security Tax (SS, or OASDI)
• Medicare Tax (Med or HI)
• Federal Unemployment Tax (FUTA, or FUI)

State Taxes are any taxes that are deposited with any one of several state agencies. Employers may have employees in more than one state, so there can be quite a few entries that fall under state taxes. Keep in mind that each state has its own rules regarding what taxes are withheld, when the deposit is due, and on what form the tax information is filed. Not all of the taxes below apply to every state.

• State Income Tax (SIT or PIT)
• State Unemployment Tax (SUTA or SUI)
• Employment Training Tax (ETT)
• State Disability Insurance (SDI)
• Local Tax
• City/County Head Tax

Employee vs. Employer Taxes

Employers often look at taxes in terms of whether they are paid by the employee, or paid by the employer. Frequently, they will refer to employer taxes as their “Payroll Expense.”

Employee taxes are any taxes that are withheld from the employee’s paycheck.

• Federal Income Tax Withheld
• Social Security Tax Withheld
• Medicare Tax Withheld
• State Income Tax (if applicable)
• State Disability Insurance (if applicable)
• State Unemployment Insurance (if applicable)
• Local Taxes (if applicable)

Employer taxes are taxes that the employer pays based on gross wages paid to their employees.

• Social Security Tax
• Medicare Tax
• Federal Unemployment Insurance
• State Unemployment Insurance
• Local Taxes (if applicable)