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The first step is determining gross pay or total of all earnings for the month. This may include normal wages, overtime, incentive pay, commissions, and any arrears. Reimbursements for job related expenses does not count as part of gross pay.
The next step on how to calculate payroll deductions is by deducting social security, Medicare, insurance, tax, any garnishments, and other voluntary or company-specific deductions from gross pay.
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Social Security and Medicare
The first deduction from the gross pay is for Social Security and Medicare, together known as as Federal Insurance Contributions tax (FICA).
The standard social security deduction is 6.2 percent of gross pay, subject to maximum limit. This annual cap or maximum limit change yearly, and stood at $106,800 for 2009-10. The Tax Relief Act of 2010 reduces the employee social security contribution to 4.2 percent from 6.2 percent for 2011.
Standard Medicare deductions are 1.45 percent of the gross pay, with no maximum limits.
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The 401(k) plans, or employer sponsored retirement savings are optional deductions that allow the employee to transfer a maximum of 15 percent of wages before tax but after social security and Medicare to a retirement fund. This amount enjoys tax exemption.
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Next in line of priority for deductions is Federal tax.
The first step is ascertaining the filing status and withholding status of the individual from the W-4 form. The W-4 form is filed by the employee to indicate tax filing status and exceptions. The withholding status declaration on the W-4 form is for claiming allowances, and directs the employer to withhold tax based on exemptions claimed. If the individual does not submitted the W-4 form to the employer, default value is “single" filing status and zero withholding allowances.
The IRS Publication 15 (Circular E), revised annually is the employer guide payroll deductions. This guide specifies the amounts of withholding allowances and tax rates. The 2011 allowance for one withholding allowance is $3700 annually. Employees may claim fewer withholding allowances than entitled, to offset tax on other income not subject to withholding.
The next step after determining withholding allowances is calculating taxable income and making appropriate deductions. Taxable income is gross pay less 401(k), less the sum of withholding allowances. The IRS prescribes a minimum amount as deemed taxable income for tipped employees.
Federal income tax depends on the filing status, and the tax deduction is a percentage of the taxable income. Publication 15 of IRS offers a table that shows the percentage to deduct for each income level and category.
The employer needs to send a W-2 form that details the federal income tax deductions made, to both the employee and the IRS at the end of the year
At present, 41 states levy state income tax. The figure varies from state to state, and the relevant state instructions are obtainable from the each state's Department of Revenue. Many states also levy state disability or unemployment insurance tax.
Besides the federal and state tax, many cities and counties charge local taxes.
One important point of note is that severance pay processed through payroll may also attract taxes.
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Wage garnishment occurs when the court orders an employer to withhold a specific amount from payroll to recover any dues owed by the employee to a third party.
Federal law limits the maximum amount of garnish deduction at 25 percent of the employee’s disposable earnings for a week, or the amount by which the employee’s weekly disposable earnings exceed 30 times the federal minimum hourly wage, whichever is less. Disposable income for this purpose is wages after taxes, social security, and Medicare.
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Next in line when determining how to calculate payroll deductions comes the optional, voluntary, or company-specific deductions. This can include:
- Premiums for any additional insurance outside FICA and 401(k) plans such as health insurance and life insurance
- Contributions to any company-specific savings plan
- Deductions for stock purchase plans
- Recovery of any dues, fines, loans, or advances
- Deduction for meals, uniforms, union dues, or other work related expenses
Such deductions depend on the employee instructions and the company rules, subject to legal compliance.
One important note on how to figure payroll deductions is that the onus of payroll tax falls on the employer. Similarly, the employer matches the employee contribution to social security and Medicare, and cannot deduct the same from the payroll when calculating payroll deductions.
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Internal Revenue Service. “Employers Tax Guide." http://www.irs.gov/pub/irs-pdf/p15.pdf. Retrieved 15 January 2011.