# Payroll Explained: Step-by-Step Guide to Calculating Payroll Taxes

![Payroll](https://www.investopedia.com/thmb/rGOF-QKE0eYuw246KZxYS2u7wAs=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/payroll-4191484-3x2-final-1-008077377d4a4d36bec1424f414b0d9d.png)

*— Investopedia / Joules Garcia*

## What Is Payroll?

Payroll involves compensating employees within the framework of state and federal regulations, including the calculation of FICA and income taxes. Whether managed in-house or outsourced to specialized firms, payroll processing is a critical business function that impacts financial reporting and tax compliance. Understanding payroll is essential for effective financial management.

Many payroll [fintech](https://www.investopedia.com/terms/f/fintech.asp) firms including Atomic, Bitwage, Finch, Pinwheel, and Wagestream are leveraging technology to simplify payroll processes. These solutions pay employees with greater convenience and speed and provide digital payroll-related documents with innovative technology-enabled services that are required by the gig and outsourcing economy.

Payroll can also refer to the list of a company's employees and the amount of compensation due to each of them. It's a major expense for most businesses and is almost always [deductible](https://www.investopedia.com/terms/d/deductible.asp). The expense can be subtracted from [gross income](https://www.investopedia.com/terms/g/grossincome.asp) to reduce the company's taxable income.

Payroll can differ from one pay period to another because of overtime, sick pay, and other variables.

### Key Takeaways

*   Payroll encompasses the process of compensating employees, which includes calculating pay, withholding taxes, and ensuring compliance with federal and state regulations.  
    
*   Employers must accurately track hours worked, calculate gross pay, and deduct required taxes and withholdings such as FICA, Medicare, and Social Security.  
    
*   Payroll can be managed in-house using software solutions or outsourced to specialized firms that handle the complexities of tax withholding and compliance.  
    
*   Professional payroll services offer benefits like simplified reporting and tax filing, but they can be costly and rely on external accuracy, posing risks to small businesses.  
    
*   Understanding payroll taxes is crucial, as these include Social Security, Medicare, and unemployment taxes, all of which have specific employer and employee responsibilities.

## How Payroll Works: An Overview

Payroll is the process of paying a company's employees. It includes tracking hours worked, calculating employees' pay, and distributing payments via [direct deposit](https://www.investopedia.com/terms/d/directdeposit.asp) to employee bank accounts or by check. Companies must also perform accounting functions to record payroll, taxes withheld, bonuses, overtime pay, sick time, and vacation pay. They must put aside and record the amount to be paid to the government for Medicare, Social Security, and unemployment taxes.

Many companies use payroll software. Employees enter their hours, and the system processes and deposits their pay.

Many medium- and large-size companies [outsource](https://www.investopedia.com/terms/o/outsourcing.asp) payroll services to streamline the process. Employers track hours worked and send this to the payroll service, which calculates gross pay. The service deducts taxes and other withholdings from earnings and then pays the employees.

## Important Payroll Compliance and Legal Factors

Employers with yearly [sales](https://www.investopedia.com/terms/g/grosssales.asp) over $500,000 must follow the [Fair Labor Standards Act](https://www.investopedia.com/terms/f/fair-labor-standards-act-flsa.asp) (FLSA). This U.S. law protects workers from certain unfair pay practices. The FLSA sets out various labor regulations, including [minimum wages](https://www.investopedia.com/terms/m/minimum_wage.asp), requirements for overtime pay, and limitations on child labor. FLSA rules specify when workers are considered to be on the clock and when they should be paid overtime.

Overtime over 40 hours a week is paid at 1.5 times the regular rate. Some employees are exempt from the FLSA and the Act doesn't apply to [independent contractors](https://www.investopedia.com/terms/i/independent-contractor.asp) or volunteers because they're not considered employees.

Some hourly workers aren't covered by the FLSA but they're subject to other regulations. Railroad workers are governed by the Railway Labor Act and truck drivers fall under the purview of the Motor Carriers Act.

The FLSA also sets out how to treat jobs that are primarily compensated by tipping. An employer must pay the minimum wage to tipped service workers unless they regularly receive more than $30 per month from gratuities.

## Pros and Cons of Outsourcing Payroll Services

One major benefit of payroll services is their ability to produce a variety of reports that simplify accounting procedures and help companies ensure that they comply with legal and tax filing requirements. Payroll services can track vacation and personal time used by employees.

> **Important**
>
> A business's accounting needs become more complex as it grows. Larger firms may have to invest in a custom enterprise resource planning (ERP) system for their accounting and payroll functions.

Outsourcing payroll means relying on outsiders for accurate accounting. The company's on-site personnel must deal with upset employees in the event of errors. Companies might also face tax penalties for errors made by the payroll service.

Another disadvantage is that payroll services are more expensive than running payroll [in-house](https://www.investopedia.com/terms/i/in-house.asp). The services might charge a set monthly fee or offer different payment structures for varying tiers of service. Payroll services may not be the best option for small companies with tight operating budgets because of their cost.

Pros of Professional Payroll Services

*   Provide access to a variety of reports
    
      
    
    Offer simplified accounting and tax compliance
    
*   Record vacation time and personal time taken by employees
    

Cons of Professional Payroll Services

*   Individuals outside the business are privy to financial and tax information.
    
      
    
    Internal staff must still help employees with payroll problems.
    
*   The company may face tax penalties due to errors by the payroll service.
    
*   Payroll services can be expensive which is a concern for small businesses.
    

## Maximizing Efficiency With Payroll Software Solutions

Some companies opt to rely on payroll software programs instead of using specialized payroll services, The company may have to pay an ongoing monthly software subscription fee when it purchases the software. Programs usually include printable tax forms and [withholding](https://www.investopedia.com/terms/w/withholding.asp) tables.

Internal payroll systems keep financial information private, though they can be time-consuming for small teams.

Small business owners use accounting software to track finances, assess profitability, and prepare for taxes. A small business can use out-of-the-box software without requiring extensive customizations.

Many types of cloud-based accounting software are available for small businesses as well. The type of industry and number of employees are two factors that will dictate which is appropriate. A [freelancer](https://www.investopedia.com/terms/f/freelancer.asp) wouldn't require the same features in a piece of accounting software as a restaurant owner.

> **Fast Fact**
>
> Investopedia conducted a review of payroll management and accounting software for small businesses and evaluated their cost, ease of use, features, integrations, and scalability. QuickBooks Online was considered the best overall software. Xero was considered the best for micro-business owners. FreshBooks was best for service-based businesses and QuickBooks Self-Employed was best for part-time freelancers. Wave was the best free software.

## Step-by-Step Guide to Calculating Payroll Taxes

How you calculate [payroll taxes](https://www.investopedia.com/terms/p/payrolltax.asp) will depend on your business and your local laws but QuickBooks provides some general guidelines.

### 1\. Calculate Your Employees' Gross Pay

You can determine an employee’s gross pay using their pay rate and your scheduled pay periods. Most businesses will pay employees weekly, every two weeks, or monthly. Calculate hourly gross pay by multiplying hours worked by the hourly rate.

> Hourly rate x total hours worked in the pay period = gross pay

Divide their annual salary by the number of pay periods in the year to calculate a salaried employee's gross pay:

> Yearly salary / number of pay periods in year = gross pay

An employee earns $50,000 a year. Their company pays employees every two weeks for a total of 26 pay periods. The employee’s gross pay is therefore $1,923.08.

### 2\. Take Out Pre-Tax Deductions

You must factor out deductions after determining gross pay. These are tax deductions but other pre-tax deductions may also apply. Pre-tax deductions include:

*   [401(k)](https://www.investopedia.com/terms/1/401kplan.asp) and some retirement plans
*   Health insurance plans
*   [Health Savings Account](https://www.investopedia.com/terms/h/hsa.asp) (HSA) or Flexible Spending Account (FSA) contributions
*   Some life insurance plans

### 3\. Deduct Taxes (FICA, Unemployment, and Income Taxes)

After pre-tax deductions, remaining pay is taxed at a 7.65% FICA rate: 1.45% Medicare and 6.2% Social Security. Other tax rates will be determined by Federal, state, or local laws and the information included on your employee’s W-4.

Calculate federal income taxes using IRS tax tables. You'll usually pay federal taxes when you pay Social Security and Medicare taxes. Report all payments on IRS Form 941.

Deduct the 7.65% FICA tax from the employee’s gross pay. As the employer, you must match each employee’s contribution. The business is responsible for submitting both the employee’s and the company’s contributions to Social Security and Medicare.

Say an employee earns $1,923 in gross pay for the pay period. Multiply $1,923 by .062 to calculate the employee’s Social Security tax contribution of $119.26. Multiply $1,923 by .0145 to calculate the employee’s Medicare tax contribution of $27.88. The employee’s FICA tax contribution is $147.14 for the pay period in total the employer must match this.

The employer must pay $294.28 to the IRS. Half is a direct expense to the company and the other half is withheld from the employee’s paycheck. Employers don’t match income tax deductions but they do pay federal unemployment taxes. The IRS's Income Withholding Assistant will help you determine how much federal income taxes your employees owe.

### 4\. Voluntary Deductions Must Be Taken From the Remaining Wages

These may include:

*   [Roth 401(k)](https://www.investopedia.com/terms/r/roth401k.asp) contributions
*   Life insurance plans
*   Long-term disability insurance plans
*   Wage [garnishments](https://www.investopedia.com/terms/g/garnishment.asp#:~:text=Garnishment%2C%20or%20wage%20garnishment%2C%20is,is%20known%20as%20the%20garnishee.)
*   Union dues

The remaining amount after all taxes and deductions is how much the employee takes home on payday.

## What Are Payroll Taxes?

Payroll taxes include Social Security which takes 6.2% of your income up to $168,600 as of 2024. This wage base increases annually. Payroll taxes also pay for Medicare which takes 1.45% of your income.

Employers also pay payroll taxes. They pay 6.2% of your income amount toward Social Security and 1.45% of your income amount toward Medicare so the government gets a total of 15.3% of your total income for these two taxes.

## What Is a Payroll Tax Cut?

A payroll tax cut would mean that fewer Social Security and Medicare taxes are withheld and taken out of paychecks. The idea is that workers and businesses would take home a little extra with each paycheck and that would encourage them to spend more and stimulate the economy. 

## What Is a Payroll Tax Holiday?

A payroll tax holiday is a deferral of payroll tax collection until a later date at which point those taxes would become due. A payroll tax deferral is intended to provide some temporary financial relief to workers by temporarily boosting their take-home pay.

## Is Payroll Part of HR or Accounting?

Payroll is essentially an accounting practice but it deals with paying the people inside a company which puts it under the domain of human resources (HR). HR manages payroll and related issues for most companies but some companies may house payroll inside the finance or accounting department and some larger companies might even carve out a distinct payroll office.

## What Is the Difference Between Payroll and Salary?

The money received by an employee from a company as compensation often comes in the form of wages or salary as well as bonuses, stock options, and commissions. These payments are an expense that's recorded as payroll by a firm.

## The Bottom Line

Managing payroll involves a meticulous process governed by strict federal and state regulations, making it both complex and time-consuming. Businesses need to track hours worked, calculate pay, withhold taxes, and ensure compliance with employment laws.

Small businesses often turn to cloud-based payroll software due to its privacy and convenience, while larger enterprises might outsource these functions or adopt comprehensive ERP systems for a streamlined approach. Understanding the nuances of payroll taxes and deductions is crucial, as errors can lead to penalties. Investing time and resources into efficient payroll management can offer significant benefits, including simplified accounting, compliance with legal requirements, and efficient financial management.

> **Article Sources**
>
> 1.  U.S. Department of Labor. "[Handy Reference Guide to the Fair Labor Standards Act](https://www.dol.gov/agencies/whd/compliance-assistance/handy-reference-guide-flsa)."
>     
> 2.  U.S. Department of Labor. "[Fair Labor Standards Act of 1938: Maximum Struggle for a Minimum Wage](https://www.dol.gov/general/aboutdol/history/flsa1938)."
>     
> 3.  U.S. Department of Labor. "[Wages and the Fair Labor Standards Act](https://www.dol.gov/agencies/whd/flsa)."
>     
> 4.  U.S. Department of Transportation, Federal Railroad Administration. "[Highlights of the Railway Labor Act ("RLA") and the U.S. Department of Transportation ("DOT") Role in RLA Disputes](https://railroads.dot.gov/sites/fra.dot.gov/files/fra_net/1647/Railway%20Labor%20Act%20Overview.pdf)."
>     
> 5.  U.S Department of Labor. "[Fact Sheet #19: The Motor Carrier Exemption under the Fair Labor Standards Act (FLSA)](https://www.dol.gov/agencies/whd/fact-sheets/19-flsa-motor-carrier)."
>     
> 6.  QuickBooks Payroll. "[What Is Payroll? Payroll Basics & Examples Small Business Owners Need to Know in 2024](https://quickbooks.intuit.com/payroll/what-is-payroll/)."
>     
> 7.  Internal Revenue Service. "[Topic No. 751, Social Security and Medicare Withholding Rates](https://www.irs.gov/taxtopics/tc751)."
>     
> 8.  Internal Revenue Service. "[About Form 941. Employer's Quaterly Federal Tax Return](https://www.irs.gov/forms-pubs/about-form-941)."