payroll taxes

In the previous post, we defined and calculated gross pay, payroll taxes, and net pay. In this post, we will discuss how to record the paycheck and the employer taxes.

You might be wondering why this is in the liabilities section of the course. So far we have discussed wage and salaries expense and payroll tax expense. How are liabilities involved?

Once you write the check for $371.28 and you have withheld taxes, those taxes that you have withheld from the check are due to the government. Those taxes represent a liability to the company because the company has an obligation to pay those taxes on behalf of the employee. Also once the employee is paid, the employer has the  obligation to pay the employer portion of the taxes. Because of these obligations, this is why you typically see these topics covered in the liabilities section of your accounting textbook.

Let’s look at what we calculated in the previous post. We calculated the net pay that an employee would receive:

PT1

We also calculated the amount of taxes that the employer would need to pay.

PT2

Now that we have those figures, we need to record this as journal entries. We are going to record this in two pieces. First, record the paycheck then record the employer taxes.

To record the entry for the paycheck, we need to consider a few things:

  • The wage expense
  • The cash paid to the employee
  • The taxes that will be paid later to the various government agencies

The wage expense is the total cost of labor incurred by the company. Wage expense is typically the gross wages paid to the employee. In this case, $480.

Although the wage expense is $480, how much did the employee actually receive? The net pay is $371.28. That is the amount of cash paid to the employee and the amount that the company’s cash will decrease by.

The difference between the gross pay and the net pay is the taxes that were withheld from the employee’s pay. This amount will be recorded as various liabilities.

Here is the journal entry to record the payment of the paycheck:

PL1

Notice the Wage Expense is debited for the gross pay. We have credited a liability account for each of the tax amounts. Sometimes you will see all the taxes lumped together into one account called Payroll Taxes Payable. We have also credited Cash for the amount of the net pay.

The entry to record the employer portion of the taxes is similar to the entry above except no cash is paid at the time the entry is recorded. We must record the liabilities that will be paid and the company expense.

PL2

The total amount of company expense is $58.80 because the is the total amount of tax that the company incurred. Use the same payable accounts for Social Security and Medicare. We also added two new payable accounts for the two different unemployment taxes.

Final thoughts

When working on payroll problems, first calculate the amount of the payroll and employer expenses. This will make doing the journal entries so much easier. It might seem like more work but it will save you time and confusion in the long run because everything is laid out for you.

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Payroll is one of the most complicated areas of accounting because of all the rules and regulations surrounding payroll. Not only do we need to calculate taxes, but we also need to subtract things like retirement benefits, health insurance contributions and other employee contributions. This post will cover the basics of payroll and payroll taxes.

What are wages and salaries?

Wages and salaries are the compensation paid to employees for the work they do for a company. Wages are calculated based on an hourly rate and the number of hours an employee works. Salaries are a fixed amount paid to employees no matter how many hours are worked. Salaries are based on an annual or monthly rate. Other items that are considered part of wages and salaries are commission paid to sales people, bonuses paid to employees, holiday pay, and vacation pay. The total compensation paid to employees based on work performed is considered to be the total wage and salary expense for the company. This is also called Gross Payroll.

What taxes are withheld from employee compensation?

Once  gross payroll has been calculated, we can start looking at deductions. Taxes generally make up the largest portion of employee deductions. These taxes include social security and medicare taxes, withholding for federal income taxes and withholding for state income taxes. We will look at each of these taxes individually to insure that you understand each of these taxes and how the tax is calculated.

Social Security and Medicare Tax

The Social Security Act was signed into law on August 14, 1935 to provide benefits to retirees, widows, and surviving children. Medicare was later added in 1965 as a health insurance program for retirees over the age of 65. Social Security and Medicare taxes are often referred to FICA tax because of Federal Insurance Contributions Act of 1935 which allowed for the collection of the taxes to pay for these programs.

Social Security and Medicare taxes are paid by employees and matched by their employers.

The current Social Security tax rate is 6.2% and is collected on all wages until an employee earns up to the Social Security wage base limit. For 2014, that amount is $117,000. For 2015, the wage base limit is $118,500. Once an employee makes more than the wage base, no additional tax is collected. The employer is also responsible for matching 6.2% of an employee’s pay up to the wage base limit. The total percentage paid by the employee and the employer is 12.4%

The current Medicare tax rate is 1.45% and is collected on all wages. There is no wage base limit for Medicare. The employer is also responsible for matching the Medicare tax at 1.45%. The total percentage paid by the employee and the employer is 2.9%.

Federal Withholding

Federal Withholding is the amount that an employer withholds from an employee’s pay that goes toward the employee’s federal income tax liability. Each year, when the employee files his or her federal tax return (typically a 1040, 1040A, or 1040EZ), the form will compare how much the employee must pay in tax with the amount that the employee had withheld from his or her paychecks. If too much tax was withheld, the employee will receive a refund. If too little tax was withheld, the employee will owe money.

When a company hires an employee, the employee is required to fill out an . On this form, the employee indicates his or her filing status and the number of allowances the employee is claiming. The employer then uses the withholding tables from  to determine how much to withhold from an employee’s paycheck. The tables are based on the frequency of pay (weekly, biweekly, monthly) and if the employee is married or single.

It is the employee’s responsibility to properly fill out the form based on the employee’s circumstances. The employer can only withhold based on the W-4 provided.

State Withholding

Currently, there are seven states that do not have an income tax. They are:

  • Alaska
  • Florida
  • Nevada
  • South Dakota
  • Texas
  • Washington
  • Wyoming

Two additional states do not have an income tax on wages and salaries:

  • New Hampshire
  • Tennessee

If you live on any of the states not listed above, your wages are subject to state withholding for income taxes. The procedure is similar to Federal Withholding. The employee fills out a state form and the employer uses that form to calculate the tax based on state withholding requirements.

Unemployment Taxes

Employers are responsible for paying state and federal unemployment taxes for their employees. This is not a tax that is withheld from an employee’s pay. It is an employer expense.

Unemployment taxes pay for benefits paid to people who have been laid off from their job.

Unemployment tax rates and wage base limitations vary state. Most states charge a higher rate to employers that lay off more workers. Typically, the wage base is very low. The majority of states have a wage base that is less than $15,000, with 19 states having a wage base below $10,000. That means unemployment taxes are no longer charged to an employer once that employer pays an employee more than the wage base. Washington had the highest wage base for 2014 at $41,300.

The federal unemployment tax rate is 6% with an $7,000 wage base. Most employers get a credit of up to 5.4% for taxes paid to their state unemployment fund. That means that most employers pay 0.6% (less than 1%) on the first $7,000 of wages paid to each employee.

Basic paycheck and expense calculations

Our ultimate goal is to calculate the employee’s gross pay and the amount of taxes that must be withheld from the employee, as well as the employer tax expense. Net pay is the amount of the check written to the employee after taxes and other deductions are subtracted from gross pay. This is also called take-home pay. Let’s see what a basic paycheck calculation would look like for a company.

Example #1

Jeff’s Geek-O-Rama has one employee. As of January 14, the first biweekly pay date of the year, the employee had worked 48 hours and is paid at a rate of $10 per hour. According to the employee’s state and federal forms, the company will withhold 10% in federal withholding taxes and 5% in state withholding taxes. The state unemployment rate is 4% on the first $10,000 of wages paid to each employee and the federal unemployment rate is 0.6% on the first $7,000 of wages paid to each employee. 

Calculate the gross pay and net pay for the January 14 paycheck. Also calculate the company’s tax expense for this paycheck. 

There is a lot of information in this short little problem and it can seem really overwhelming. Let’s start with what the question wants us to do.

  1. Calculate the gross pay
  2. Calculate the net pay
  3. Calculate the company’s tax expense

Now we can tackle each of these one at a time. It is really important to learn the terminology so you can calculate the correct figures.

Gross pay is the amount of wages the employee earned. This is based off the number of hours the employee worked and how much the employee is paid each hour. In this case, the employee worked 48 hours over a two-week period. We know this because we are told the employee is paid biweekly (every two weeks). The employee is paid $10 per hour.

48 hours worked x $10 per hour = $480.00 gross pay

Net pay is the amount the employee takes home after all the taxes are deducted. First, determine which taxes should be withheld from the employee.

  • Social Security
  • Medicare
  • Federal Withholding
  • State Withholding

We need to calculate each of these taxes.

Social Security is 6.2% of the gross pay. Multiply the gross pay by 6.2% or 0.062.

$480.00 x 0.062 = $29.76 Social Security tax

Medicare is 1.45% of the gross pay. Multiply the gross pay by 1.45% or 0.0145.

$480.00 x 0.0145 = $6.96 Medicare tax

According to the problem, federal withholding is 10% of gross pay. Multiply gross pay by 10% or 0.1.

$480.00 x 0.1 = $48.00 federal withholding tax

According to the problem, state withholding is 5% of gross pay. Multiply gross pay by 5% or 0.05.

$480.00 x 0.05 = $24.00 state withholding

All the taxes that will be withheld from the employee’s pay have been calculated. For net pay, subtract all the taxes from the gross pay.

PT1

Of the $480.00 the employee earned, the employee will take home $371.28. The rest of the money, $108.72 will be paid to the federal and state governments on the employee’s behalf.

The last portion of the problem asks us to calculate the employer taxes. First, list the taxes that the employer must pay.

  • Social Security
  • Medicare
  • Federal Unemployment
  • State Unemployment

We need to calculate each of these taxes.

Social Security is 6.2% of the gross pay. Remember that the employee pays this but the employer does as well. Multiply the gross pay by 6.2% or 0.062.

$480.00 x 0.062 = $29.76 Social Security tax

Medicare is 1.45% of the gross pay. This is another tax that is paid by both the employee and the employer. Multiply the gross pay by 1.45% or 0.0145.

$480.00 x 0.0145 = $6.96 Medicare tax

According to the problem, federal unemployment is 0.6% of the first $7,000 of wages paid to each employee. Since this is the first payroll of the year, the employee has only earned $480.00 and is well below the $10,000 threshold. Multiply the gross pay by 0.6% or 0.006. Remember, this is less than 1% so it is 0.006.

$480.00 x 0.006 = $2.88 federal unemployment tax

According to the problem, state unemployment is 4% of the first $10,000 of wages paid to the employee. Since this is the first payroll of the year, the employee has only earned $480.00 and is well below the $10,000 threshold. Multiply the gross pay by 4% or 0.04.

$480.00 x 0.04 = $19.20 state unemployment tax

Add up all the employer taxes to calculate the total employer tax.

PT2

This is an expense to the employer on top of the wages paid to the employee. Therefore, the total cost of the employee to the employer is $480.00 in wages plus $58.80 in taxes.

In the next post, we will discuss how to record the journal entries for this payroll transaction.

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