Starting a business is always exciting. You get a chance to optimize your small business, find clients, new directions, etc. An expansion of a business means you need employees. And here comes the not-so-exciting part — dealing with payroll.
Payroll is a nightmare for most new business owners. Employers have to consider different types of pay, deductions, withholdings, benefits, etc. Not to mention, companies must meet all labor laws.
The main task is to determine the gross pay of every employee, then withhold all legal deductions to pay taxes, and then determine the net income. It may be difficult in the beginning, but eventually, every employer learns how to simplify the process.
In this article, you will learn what gross and net pay are and what’s the difference between these two concepts. Readers can also learn how to calculate gross and net pay.
What is Gross Pay?
Gross pay is the total amount of money an employer pays their employees before withholding taxes and other deductions. For example, if an employer states that they pay their employee $50,000 in annual salary, it means the employee earns $50,000 in gross pay.
What is Net Pay?
Net pay is what an employee gets as a salary or wage after taking out all withholdings and deductions from their gross pay. Such FICA (Federal Insurance Contributions Act) deductions as Social Security tax and Medicare are withheld automatically.
Other deductions depend on each business and individual case. For instance, they may include the following benefits:
- health care;
- dental care;
- life insurance;
- retirement contributions.
These are optional benefits, and the list may be expanded. Employers paying for these benefits withhold expenses from employees’ gross pay.
The Difference Between Gross Pay and Net Pay
When hiring an employee, the employer offers a contractual agreement. This agreement includes the salary in gross pay. The gross pay, as mentioned, is the amount of money before withholdings.
The net pay is the revenue an employee gets after the employer calculates all possible deductions. The net pay shows the real amount of money employees make and take home.
Payroll has to include both the net and gross pay on pay stubs. A pay stub isn’t a paycheck. It’s a formal document that enlists all data, including deductions and withholdings, so employees understand how the employer calculates their income.
Typically, an accountant includes gross pay as the first number. The next section includes details about withholdings applicable to employees. Then the accountant should calculate and add the net pay amount.
Calculating Gross Income
It’s easy to understand the difference between net and gross pay, but it’s not so easy to calculate these two concepts. The tricky part here is that employers must calculate gross pay differently for salaried and hourly employees. Keep reading to learn more about each method.
Salaried Employees
Employees receiving fixed remuneration per year are called salaried employees. The salary included in the employment agreement contract is official gross pay. It’s also possible to calculate the gross pay from regular pay statements — in case you are an employee and want to understand your gross pay.
Employers may check payroll statements to find monthly payments and add them up to get an annual gross income. For example, an employee makes $4,500 per month as gross pay. Take $4,500 and multiply this number by 12. As a result, the employee gets $4,500 x 12 months = $54,000.
If an employees receives other types of income from their employer, such as bonuses, they must include this in income. Employees must include the full amount of bonuses before calculating taxes and gross salary. It’s critical to include bonuses in the gross pay since they are taxed at a different rate than regular revenue.
Here’s a simple example, if an employee has received $7,000 in bonuses, this amount is taxed at a 22% flat rate. The regular salary is taxed at a lower or higher rate (depends on filing status and income).
Wage Employees
It’s easier to calculate the gross pay at the end of the year since most workers don’t know how many hours they will work during the year. As soon as the worker gets the last pay statement, they can easily calculate their entire gross earnings.
Note: if an employee receives guaranteed or regular hours from their employer, they can easily determine their weekly, monthly, or yearly gross pay. The employee’s task is to multiply the number of hours they receive each week by the total amount they earn in an hour.
Here’s an example: an employee makes $20 per hour with a guaranteed 38 hours of work per week. The employee gets $760 per week, gross income per month is $3,040, and gross annual pay is $36,480.
If the employer doesn’t offer paid time off, then the gross pay should decrease. This fact must be included when estimating gross annual pay. If the gross pay increases throughout the year, then the employee has to adjust their revenue.
Net Pay: Formula
Now that you know how to calculate gross pay, we can determine the net pay. Here’s a simple formula to calculate net pay:
Gross pay – all deductions (including benefits) = net pay.
It’s a straightforward formula that enables employers to calculate net pay easily. But it still has a tricky part — tax rates. Each employee has to fill out Form W-4 and hand it back to the employer. According to this form, every employer or accountant figures out the amount of taxes to withhold. As mentioned, benefits vary in different companies.
Calculating Net Pay from Gross Pay
As mentioned, employers have a responsibility to withhold taxes from employees’ paychecks during all pay periods. But what tax deductions to claim to calculate workers’ net pay? The main income tax withholdings from a worker’s paycheck include local, state, and federal income taxes.
All staff members must fill out a W-4. It’s the document that asks for tax deduction details, including special considerations to the number of people (and dependents, if any) in their families.
Employers have to check with the IRS tax charts in order to calculate applicable deductions in every case. Such calculations help determine the amount of payroll taxes that have to be withheld.
Another important part is obligatory withholding tax. Obligatory withholdings consist of:
- Medicare tax (1.45%);
- Social Security tax (6.2%).
Together this tax (7.65%) is called FICA. An employer withholds deductions to send them to the IRS on behalf of the employee. The rest is net pay, and it goes to the worker.
In some cases, employers have to withhold wage garnishment deductions. Garnishments could include the following:
- student loan;
- additional taxes and credit card loans;
- unpaid child support.
And don’t forget to withhold voluntary deductions. A voluntary deduction is an already mentioned benefit offered by the company. For instance, some companies offer to pay for your health and life insurance, retirement funds, etc.
It is easy to determine gross pay, but as you see, calculating net pay may take a while. The tricky part is that companies need to make individual calculations according to W-4 forms. You can consider asking for the help of an accountant or consider using accounting software.
