Paying an employee at the end of the month is not just a one-stroke transfer. It requires paperwork, formalities, and a lot more. When it comes to payroll, the money you finally roll out to the employees can be divided into two parts; gross pay and net pay. The question that gets asked much is, what is gross vs net. To be more precise, what is gross pay vs net pay?
And we are here to bail you out from that dilemma. From spelling out the difference between gross and net to telling you the gross pay definition, over to net income formula, and much more, let this be your handy guide to knowing the difference between the two major components of payroll.
Gross vs Net: What is Gross Pay?
Gross pay definition can be spelled out in simple terms. It is basically the gross amount that is payable to the employee, from the employer. It is inclusive of everything the employee receives, whether in cash or kind. For instance, not just the monetary compensation, but goods, any property, and even the services that are non-exempt from tax form a part of gross wages.
One thing to note is that gross pay comes into factor only for exempt employees because they are the ones receiving fixed pay. This is the amount that is calculated after divided their annual salary by the number of yearly pay periods. Usually, there are 26 pay periods in a year. That means an employee will be getting 26 paychecks in a year. The gross pay is calculated by dividing the yearly salary by the pay period number.
The gross vs net question arises because you may wonder if this is the payment owed to the employee, why isn’t gross pay equal to net pay? If we go by the basic definition, the net is arrived at by deducting the relevant discussions from gross. However, in the case of net income, there are a few more laws and factors that are taken into account. Let’s find out.
Gross vs Net: What is Net income?
We now know what is gross pay. What is the difference between gross and net pay, then? For that, you now need to know about net income. That can be derived by simply applying the net income formula.
Net income = Gross income – Deductions (Required and voluntary)
Most of the payroll tax deductions include the following:
- Social security taxes
- Federal income tax
- State taxes
- Local income tax withholding
- Other taxes such as state disability or unemployment insurance, community college taxes, etc
Net income is the final payment that goes on the final paycheck that is disbursed to the employee. Also, it is different for an exempt employee and a non-exempt employee. While the former gets a fixed salary, the latter’s paycheck also includes overtime and other reimbursements.
All in all, net pay is the final in-hand income received by the employee, after reducing relevant and mandatory deductions from the gross pay. This is the main difference between gross and net pay.
How to Understand Employee Deductions from Gross Pay?
We have discussed the gross pay definition. We also know what is net income. And the key difference between the two is the deductions. It’s time to delve a little deeper into those.
Mostly, the amount to be deducted from the gross pay is gauged by the number of deductions that the employee has disclosed via form W-4. This, along with the Internal Revenue Services (IRS) charts is used as the basis for calculating deductions. Further, deductions also depend upon the number of employee’s family members. For instance, a single employee can avail of a single deduction. A married employee who has two children can claim four deductions. The key is to not overpay taxes, yet pay enough. Thus, until the employee files the return to claim a refund, the government is free to use the tax money.
It is to be noted that any garnishment ordered by the court is also a part of these deductions. However, apart from federal laws, the state may also have its own laws. Thus, while hiring, it is always a sane decision to consult your legal team when it comes to setting up payroll, taxes, deductions, and more.
How to Calculate Gross Pay?
The first thing that you need to know as you go about calculating gross pay, is whether your employee is receiving an hourly rate or if they are paid a fixed salary. Further, in continuation, it is important to know the payroll period length and the number of hours worked, respectively.
After knowing the aforementioned elements, it is quite easy to answer the question; how to calculate gross pay.
For Fixed Salary Employees
In the case of employees who receive a fixed salary, you can calculate the gross salary by dividing the annual pay by the number of paychecks due or the number of pay periods. For instance, if an employee’s cumulated gross pay is $60,000 per annum and the organization pays them 12 times a year, that means their gross pay is 60000/12, i.e. $5000.
For Hourly Employees
If the employee payment frequency is hourly, simply take the fixed hourly wage or salary that and multiply it by the number of hours worked. For instance, if an employee gets paid $50 per hour and has worked for 50 hours for the next two weeks, the total gross pay would be 50×40, i.e. $2500.
Now that you know how to calculate gross pay, it’s time to know about the net income.
How to Calculate Net Income?
We have almost fixed your dilemma of gross pay vs net pay by charting out the basic differences between gross and net. You know that there are deductions that separate the gross salary from net income. Now is the time to know how to actually calculate net income. You can use the net income formula. Alternatively, you can also use a net income calculator.
Let us first find out about the net income formula. To put it in simple terms, the net income formula simply states to minus the deductions from the gross pay to arrive at the net income. We have already discussed these deductions at length. But for your convenience, here is another simpler explanation. Let’s divide these deductions into three categories: tax withholding, pre-tax deductions, and post-tax deductions. We subtract pre-tax deductions from the gross pay before calculating the tax liability. On the other hand, as the name suggests, we calculate post-tax deductions after subtracting the pre-tax deductions and tax liability.
While applying the net income formula is usually the most preferred solution, there are net income calculators available as well that help facilitate the calculations to avoid any confusion. There are various tools and plugins available that will calculate the net pay if you enter certain figures such as gross pay of the employee, the deductions, etc. This eases your work by quite a bit. Some of the net income calculator plugins that you can use to ease your work are the ones by thetaxcalculator.net and the one by Ifa.
What are the Pre-tax Deductions that Affect the Net Income?
To understand the gross pay vs net pay dilemma, it is important to understand the deductions. As discussed, the best way to calculate net income is by deducting the tax withholding, pre-tax deductions, and post-tax deductions. So, what are these pre-tax deductions? Let’s find out.
There are certain deductions that you should take into account before withholding taxes. Subtract these from the gross pay. Know as pre-tax deductions, these include the following:
- Contributions to pre-tax retirement accounts
- Insurance premium for health, vision, and more
- Commuter benefit deductions
- Pre-tax health savings account contributions
Please note that the list is illustrative and not exhaustive.
These deductions are mostly for the benefit of the employee. Even though the employee can later avail these, they still lower the net income. Thus, you have to factor these during the calculations.
What are the Post-tax Deductions that Affect the Net Income?
Now, the post-tax deductions. These are not the deductions that are per se for the individual benefit of the employee, in the present or in the future. Nevertheless, since they reduce the net income, they have to explain it. Take a look at the following examples of post-tax deductions:
- Garnishments ordered by the court
- Union dues
- Donations
- Post-tax retirement contributions
- Life insurance premiums
- Disability insurance premiums
In What Way does Gross Pay vs Net Pay Affect Employer’s Taxes?
As you are the employer, the gross salary and net income of your employees affect your organization’s tax obligations too. You have to pay half of the FICA taxes of your employees, which roughly amounts to 7.65% of the employee salary. Out of this 1.45% goes towards employee medicare and the remaining 6.2% goes towards the social security of the employee. Note that there is a social security base that applies to employers. That means that if your employee’s wages exceed the base rate, then the organization is no longer under the obligation to pay social security taxes on their behalf.
The other tax which the employer pays is called FUTA tax or the tax under the Federal Unemployment Tax Act, which basically funds the unemployment benefits program.
When you calculate taxes as an employer, remember that you have to take the employees’ gross pay into account and not their net income.
Is it Important to Understand the Difference Between Gross and Net Pay?
Absolutely. As we have explained, not only is it imperative towards calculating and setting up a proper payroll system, but also impacts the organization’s tax liabilities. Thus, it is important to settle the gross pay vs net pay debate once and for all and know all the facets of payroll clearly, to function in the best way possible.
Does your organization have a payroll process in place? How is the gross pay vs net pay system there? Do share with us @HarmonizeHQ
