Employees only receive a portion of their initial salary, as a percentage from their income needs to go towards tax liabilities and other mandatory deductions.
The amount employees receive after these expenses have been deducted is known as their net pay.
This guide will go through the details of what net pay is, what type of deductions decrease it, and how you can calculate net pay for your small business accounting.
Read along to learn about:
- What Is Net Pay?
- What’s the Difference Between Net Pay and Gross Pay?
- How to Calculate Net Pay (Step-by-Step)
- Automate Net Pay with Payroll Software
What Is Net Pay?
Net pay, commonly known as take-home pay, is the income employees receive after deductions and withholdings have been removed from their wage or salary.
Those deductions can be either mandatory or voluntary.
Mandatory deductions are deductions required by law, such as:
- Federal income taxes
- Local income taxes
- State income taxes
- Wage garnishments, which vary from garnishments for child support, consumer debt, student loans, etc.
Voluntary deductions apply when employees request to pay for services such as:
- Medical care
- Life, accident, disability insurance
- Retirement savings plan
- Health savings account
- Union dues
If you want to learn more about the payroll process and the different types of payroll and income taxes, head over to our complete guide on understanding payroll.
Form W-4
When you’re hiring a new employee, one of the many documents you need to have them complete is the W-4 form. As an employer, a W-4 form tells you the exact amount in tax you have to withhold from your employee’s paycheck.
If this form isn’t filled out correctly, your employees could risk underpaying their taxes throughout the year and owing large sums to the revenue service department.
What’s the Difference Between Net Pay and Gross Pay?
As we’ve mentioned, net pay is the money your employees receive after taxes and withholdings.
These taxes and withholdings are deducted from the initial, basic salary or wage, known as an employee’s gross pay.
So, in other words, gross pay refers to the amount you pay your employees based on the agreed-upon salary or wage, before mandatory and voluntary deductions.
According to the Internal Revenue Service, gross pay includes all income you receive in terms of cash, goods, property, services, before taxes and other withdrawings are deducted. Reimbursements, bonuses, overtime work are all forms of income included in gross pay.
How to Calculate Net Pay (Step-by-Step)
Step 1: Determine Gross Pay
To calculate gross pay, you have to take your employee’s total annual salary and divide it by the number of pay periods within that year.
So, for instance, if an employee has an annual salary of $48,000, and you pay them twice a month, you have to divide their annual salary by 24. Their gross pay would amount to $2,000.
When you’re working with wage employees, you can determine gross pay by multiplying the hours they’ve worked by the pay rate. Make sure to also take into account any deductible work hours from absences.
As an example, let’s assume your employee works 25 hours a week for $10 per hour. Their weekly gross pay would be 25 hours x 10 per hour = $250.
Step 2: Determine the Sum of Pre-Tax Deductions
Some voluntary deductions can be calculated on a pre-tax basis.
This means you take out a voluntary deduction from your employees’ payroll before calculating mandatory taxes. Pre-tax deductions lower your employee’s taxable income and payroll taxes.
Now, whether or not a deductible is pre-tax depends entirely on your country’s tax rules as well as your business policies. Your employees may not have any pre-tax deductibles, so if that’s the case, you can skip this step altogether and directly subtract deductions from gross pay.
To illustrate how pre-tax affects net pay, let’s assume an employee with a $3,000 biweekly gross pay needs to compensate for the following pre-tax deductions:
- A healthcare deduction that amounts to $40
- A retirement plan deduction that amounts to $50
After these $90 worth of pre-tax deductions, the employee will be taxed for $2,910 worth of income instead of the full $3,000 of gross pay.
Step 3: Calculate Taxes and Add Up Post-Tax Deductions
After you’ve determined and subtracted your pre-tax deductibles (if your employee has any), you have to use the remaining taxable income to calculate federal, local, and state taxes. This can be done manually, through software, or using calculators online.
Then, the very last calculation you need to make is to determine post-tax deductions.
Post-tax deductions are voluntary deductions you subtract after calculating your taxes. They could be withholdings for retirement plans, insurance, healthcare, or any type of voluntary deduction.
Just like with pre-tax deductions, all you have to do is know what post-tax deductibles an employee has, and add them up.
And again, as tax law can be confusing, we recommend talking to your state Department of Labor and/or a law attorney when you’re settling payroll taxes and deductions.
Step 4: Find Net Pay
The general formula for net pay is as follows:
If you have pre-tax deductions, subtract those from the gross pay, and then calculate taxes from the remaining amount.
In case you don’t, then you can calculate net pay by directly removing taxes and deductions from gross pay.
Automate Net Pay with Payroll Software
Don’t want to go through the hassle of manually calculating and distributing employee payroll? Then use cloud accounting software instead.
With Deskera, managing net pay and streamlining the payroll process is as easy as 1-2-3!
From the Deskera Payroll Software, you can set up custom bonuses, voluntary and mandatory deductions, and other pay components for each employee.
Then the software will identify these components and automatically calculate salary and wages, based on a pre and/or post-tax basis.
The platform also allows you to set up flexible pay schedules, maintain detailed records for each employee, send payroll automatically through a direct deposit feature, and so much more.
Give Deskera a try out right now, by signing up for our completely free trial. No credit card details necessary.
Key Takeaways
And that’s a wrap!
For a quick recap, here are some of the main points we’ve covered in today’s post:
- Net pay is what employees receive after withdrawings and deductions have been subtracted. These deductions can either be mandatory or voluntary.
- Mandatory deductions include state and local taxes, while voluntary deductions include withdrawings for insurance, retirement plans, healthcare, and so on.
- The initial, untouched salary amount employees earn, is known as the gross pay. To calculate net pay, taxes and other withdrawals are subtracted from gross pay, either on a pre-tax or post-tax basis.
- With payroll software like Deskera, you can automate your entire payroll process, within seconds.
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