It's essential to have a firm understanding of gross and net pay definitions, as well as how to calculate each. Here is a rundown of everything you need to know.
We know — it’s not the most exciting of topics. As an employer, though, calculating your employees’ net pay is an essential part of managing payroll. If your paychecks don’t define net pay and gross pay in sufficient detail, it can lead to a variety of accounting headaches and leave you vulnerable to penalties.
While larger companies have entire accounting departments that manage taxes and payroll, small business owners often have to muddle through it themselves. That’s why it’s essential to have a firm understanding of gross and net pay definitions, as well as how to calculate each. Ready to get started? Here is a rundown of everything you need to know.
If your small business is required to issue pay stubs under the Fair Labor Standards Act (FLSA), you’ll need to provide a clear breakdown of exactly how much each staff member takes home at the end of each pay period. That said, what does net pay mean on your paychecks?
Many net pay definitions simply state that gross pay is before taxes and net pay is after taxes, but there’s a bit more to it than that. The most widely accepted net compensation definition is as follows:
Gross pay - Payroll taxes - Other deductions = Net pay
You see, it’s not just federal and state income taxes that need to be subtracted, but all other relevant deductions, including:
Let’s put this into practice with an example. Suppose an employee wants to know what is the net amount of pay on their salary of $4,000 per month. If deductions for all taxes and benefits total $800, $3,200 would be their remaining net pay, meaning that’s the amount they take home to spend.
Of course, employees might not necessarily use the term “net pay” in their discussions with you. It’s much more likely they’ll use a less technical description for the money they take home. So, what is another name for net pay? Yep, you guessed it: the most common alternative used by workers is simply “take-home pay.”
Having firmly established that a reliable net pay definition refers to the take-home salary after taxes and deductions, let’s take a more in-depth look at gross pay.
When hiring for a position, it’s standard practice to list the gross amount, which is also commonly referred to as a “base salary,” as it excludes any additional incentives or benefits. However, why is this standard practice?
Well, there are a couple of valid reasons. For one thing, the gross figure is higher and, therefore, likely more attractive to candidates. However, the main reason is that, unlike gross salaries, net figures can vary significantly even between workers on the same pay scale. If you only listed a net pay definition, economic-savvy applicants would be quick to point this out and question your deductions.
Ultimately, stating gross pay figures in salary descriptions and allowing employees to control their net earnings by making their own financial decisions about additional contributions and deductions is the best way to create transparency and trust in your payroll system.
Payroll and taxation are heavily regulated, and you can face hefty penalties if your records are incomplete or you make incorrect salary payments or tax submissions. With that in mind, it’s a good idea to maintain up-to-date documentation that states clearly how much money you’ve paid, how often, and to whom.
Follow these steps to calculate net payments accurately for each of your employees.
To calculate an employee’s gross pay in any cycle, you’ll first need to establish the base amount of salaried compensation. For full-time staff, divide the gross annual salary by the number of pay cycles per annum. For hourly workers, multiply the number of hours worked by the hourly rate. Once you have a figure, add on any relevant commissions, bonuses, or overtime payments.
It is your duty as an employer to deduct the applicable federal and state income taxes, plus Social Security (6.2%) and Medicare (1.45%). These must be reported and submitted to the government in your Employer's Quarterly Income Tax Return using IRS Form 941.
As we highlighted earlier, there are several other possible deductions. Be sure to carefully calculate and double check the exact deductions for each individual to ensure no errors are made.
At this point, you should have an accurate total for payroll taxes and other deductions for each employee. Next, deduct that amount from each individual’s gross pay figure for that cycle to calculate the total net pay, meaning how much you need to provide in their pay packet.
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