Payroll Terms To Learn Before Doing Payroll

Handling your own payroll for your business can be tricky because the payroll/payroll tax process involves a vocabulary all its own. These terms are the most important ones you'll encounter as you begin to work on employee paychecks and start the payroll process.

Paychecks are used for two main purposes: accounting, as you prepare employee paychecks and include payroll amounts in your business accounting system, and taxes, as you collect, pay, report, and send employment taxes according to federal and state tax requirements.

You should be comfortable with the common terminology even if you have an accountant to do your payroll accounting or you use payroll software or a payroll service company.

Payroll

Payroll is a general term and it has several meanings:

• The amount of money paid to all employees on 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

Gross Pay

Gross pay is the total paid to an employee each pay period before any deductions for taxes or other purposes are made. It's determined in different ways for salaried and hourly employees.

Gross pay is stated as an annual amount for salaried employees. The annual salary is divided by the number of pay periods in the year to determine gross pay for a pay period.

Gross pay is the worker's hourly rate times the number of hours worked in that pay period for hourly employees. Overtime is included in gross pay, too.

The Internal Revenue Service (IRS) doesn't discuss gross pay. It uses the terms "gross income" or "total income." This is the income that must be reported on an employee's Form W-2, their annual wage tax report.

Net Pay

Net pay is the amount of pay an employee receives after all withholding and deductions from gross pay have been made. It's 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. 

Pay Periods

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

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. Most deductions don't affect the amount of an employee's taxable income, but some are considered pre-tax. These are subtracted from the employee'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 another tax form. 

Wage Garnishment

Some employees must make a third type of payment. Courts sometimes issue garnishment orders for debts like student loans, small claims judgments, child support, or other amounts the employee owes. You must comply with the order if you receive a garnishment notice ordering your business to garnish wages. Garnishment is typically done 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 the hours they've worked.

Overtime

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 vs. 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, or executive positions, sometimes referred to as a "white-collar exemption."

But not all "white collar" professionals are exempt from overtime. They must be over a standard salary level of $684 a week ($35,568 a year for a full-year worker) to be exempt. You must pay them overtime if an exempt employee is paid less than $684 a week.

Other workers are considered non-exempt and you must pay them overtime. A worker is considered non-exempt and eligible for overtime unless an exemption can be proved by the employer.

Compensation

Employee compensation is a term that's often used instead of "pay," but it's a more general term that includes other payments to employees. Some types of compensation are taxable to the employee.

• 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

These types of payments are taxable, so you must separate them out when you're doing payroll accounting and include them in the employee's taxable wages for the year. You must report these wages on the employee's W-2 form.

Frequently Asked Questions (FAQs)