Handling your own payroll for your business can be tricky because, for one, the payroll/payroll tax process involves a whole new vocabulary.
These terms are the most important ones you will encounter as you begin to work on employee paychecks, which signifies the start of the payroll process. These paychecks are used for two main purposes:
- For accounting, as you prepare employee paychecks and include payroll amounts in your business accounting system
- For taxes, as you collect, pay, report, and send employment taxes according to federal and state tax requirements.
Payroll is a general term, and it has several meanings. It can be:
- The amount of money paid to all employees in a payday, as in, "We ran payroll this morning for tomorrow's payday."
- The financial records of a company relating to the payment of wages and salaries to employees
- The total record of earnings of employees for a year
For salaried employees, gross pay is stated as an annual amount. To determine gross pay for a pay period, the annual salary is divided by the number of pay periods in the year.
For hourly employees, gross pay is the worker's hourly rate times the number of hours worked in that pay period; overtime is included in gross pay, too.
The IRS doesn't discuss gross pay; it instead uses the term "gross income," or "total income," which is the income that must be reported on an employee's annual wage tax report (Form W-2).
Net pay is the amount of pay an employee receives after all withholding and deductions from gross pay. In other words, net pay is the amount of the employee's paycheck.
The calculation for net pay begins with gross pay. Then amounts for federal and state income taxes are taken out, as well as FICA tax (Social Security and Medicare). Finally, discretionary deductions like health plan contributions and retirement plan amounts are taken out.
A pay period is a recurring length of time over which employee pay is recorded and paid. Some common pay periods are:
- Monthly (12 pay periods a year)
- Weekly (52 pay periods a year)
- Bi-weekly (every other week, 26 pay periods a year)
- Semi-monthly (twice a month, 24 pay periods a year).
The number of pay periods in a year is important in computing total pay for employees for a year.
Withholding and Deductions
|Federal income tax||Insurance premiums|
|State income tax||Retirement plan contributions|
|FICA tax||Union dues|
Withholding refers to amounts taken from an employee's paycheck for several different types of taxes:
- Federal income tax
- FICA taxes (Social Security and Medicare)
- State income taxes
Deductions are other types of payments taken out of an employee's paycheck. Most deductions don't affect the amount of an employee's taxable income, but some are considered pre-tax. Pre-tax deductions are subtracted from the person's gross income to reduce their taxable income. Examples are retirement plan contributions and some health care costs.
An employee's federal income tax withholding is determined by using the information on a Form W-4 completed by the employee at hire, and for state income tax by a state W-4 or other tax form.
Withholding doesn't have to be approved by employees, because these amounts are required by law. All deductions from an employee's paycheck must be approved by the employee in writing except for deductions ordered by a court.
In addition to withholding and deductions, there's a third type of payment that some employees must make. Courts sometimes issue garnishment orders for debts like student loans, small claims judgments, child support, or other amounts the employee owes. If you receive a garnishment notice ordering your business to garnish wages, you must comply with the order. Typically, garnishment is on a per-paycheck basis, so you'll have to add this to your list of deductions.
Salaried vs. Hourly Employees
The terms "salaried employee" and "hourly employee" relate specifically to how these employees are paid. Salaried employees are paid an annual salary, while hourly employees are paid an hourly rate times hours worked.
Overtime is the additional amounts paid to hourly employees who work over 40 hours in a week, who work on weekends, or other additional amounts. Overtime must be paid at one-and-a-half times the person's hourly pay rate for employees who work more than 40 hours in a workweek. Of course, you can pay overtime at higher rates.
Overtime is calculated differently for hourly and salaried employees. Most salaried employees are exempt from overtime, but your business may be required to pay overtime to some lower-paid exempt employees.
Exempt and Non-Exempt Employees
Exempt means "exempt from overtime." Exempt and non-exempt employees are categorized typically by the work they do. Most exempt employees work in professional, managerial, and executive positions sometimes called a "white-collar exemption."
But not all "white collar" professionals are exempt from overtime. To be exempt, they must be over a standard salary level of $684 a week ($35,568 a year for a full-year worker). In other words, if an exempt employee is paid less than $684 a week, you must pay them overtime.
Other workers are considered non-exempt, meaning you must pay them overtime. A worker is considered non-exempt (eligible for overtime) unless an exemption can be proved by the employer.
The concepts of salaried vs. hourly and who is and is not exempt from overtime are often confusing. This comparison might help sort out the confusion.
|Salaried Employees||Hourly Employees|
|Paid based on an annual amount||Paid an hourly rate|
|May be exempt based on the specific position||Never exempt|
|Lower paid salaried employees must receive overtime pay||Always receive additional pay for overtime|
Employee compensation is a term that is often used instead of using the term "pay," but it is a more general term that includes other payments to employees. Some types of compensation that are taxable to the employee include:
- Tip income
- Benefits of using a company car
- Stock options
- Bonuses, awards, and gifts to employees (unless they are very small)
- Some commuting and transportation benefits
- Some educational benefits
- Other benefits, like meals, may or may not be taxable to employees, depending on the circumstances
Because these payments are taxable, you must separate them out when doing payroll accounting and clude them in the employee's taxable wages for the year and report these wages on the employee's W-2 form.
Payroll Terms FAQs
Can an employer fire an employee who has their wages garnished?
Federal law protects an employee from being fired because their wages have been garnished for one debt, and it limits how much can be deducted from an employee's paycheck each week.
In some years, there are 27 periods for bi-weekly employees. How do I handle that?
You have several alternatives for paying the extra 27th pay period. The two important things to remember are don't make it too complicated, and be sure to give employees notice if you are making any changes to their paychecks.
How long should I keep payroll records?
The U.S. Department of Labor requires employers to keep all payroll records for three years. This DOL Fact Sheet has more details. The IRS requires that all tax records, including those for payroll taxes, be kept for at least three years, and longer in some cases.