A pay stub which is also commonly referred to as a paycheck stub or payslip is an important document that contains the details of the wages or salary disbursed to an employee. It lists the income earned for the pay period, including the taxes and other deductions applicable to the gross pay. The information included in a Paystub presents the collective figure that the employee finally receives as net salary or wages, after applying taxes and other standard deductions, as applicable.

The standard pay stub deductions include standard taxes such as federal and state income tax. These federal and state taxes account for much of the difference between your gross income and net income. There would be other deductions as well, depending on the various components and structure of your income.

Let's look at how these deductions work and how you can calculate your taxable income. 

What is Taxable Income?

Any income that you earn – be it in the form of hourly pay, overtime wages, a salary, commissions, bonuses, and even severance pay - is subject to taxation by the government. The section of your income that is subject to tax is called taxable income, because your total earnings may not be taxable. 

The amount of income to be taxed is based on the total income earned, minus certain deductions allowed under the Internal Revenue Service (IRS) tax code.

Some of these pre-tax deductions could be contributions to a 401(k) retirement plan, a health insurance plan or payments made to benefits under what's referred to as a Section 125 cafeteria plan. Please note that these deductions factor into reducing the amount of Federal Income Tax (FIT) withheld, but not all apply to Social Security and Medicare taxes.

Once deductions are subtracted, the remaining income is your taxable income. This is the amount the federal government considers to determine the amount of FIT to be withheld. There are additional taxes that are deducted based on the tax rules at the respective state and local levels of government.  Different states and cities have their own rules for state income tax.

How to Calculate Taxable Income

Since calculating the taxable income can be complicated, let us understand the process in detail.

1. Gross Wages

The total money paid to an employee is their gross income – including their tips, overtime and even reimbursements for items like tuition and business-related expenses. This is the amount that the IRS takes as the total income, on which then standard taxes will be applied.

2. Non-Taxable Income

Some portions of the employee's earnings are marked as non-taxable income. The components that are exempted from tax could be certain business expense reimbursements, and educational assistance, up to a specific limit. These are deducted from gross wages to arrive at the taxable wages total.

3. Deductions

The other components that would be deducted from your gross income could be your contribution to a business health insurance, a retirement or pension plan, or flexible spend accounts (FSA) or any other payment that is tax-exempted. Now, after subtracting these components from your gross income, the remaining amount is considered as taxable income.

4. Employer-provided Fringe Benefits

Some employers also provide benefits which are considered taxable and get added to your total income amount. For example, if your company compensates you for relocating or moving, this amount will become part of your taxable income.

5. Total Taxable Income 

After all the additions and deductions to gross wages are calculated, we now have the amount used for determining tax liability, the employee's taxable income. The actual amount of tax taken from an employee's pay stub is also dependent on how they file taxes, i.e. single or married, and the number of allowances.

This is the formula for calculating your taxable income:

(Gross wages) - (Non-taxable wages) - (Pre-tax deductions) + (Taxable benefits) = Taxable Income

How to Calculate Payroll Taxes (FICA)

FICA or Federal Insurance Contributions Act is a mandatory payroll tax deduction used to fund programs like Social Security and Medicare (health insurance for those over 65).

Current FICA tax rates

The current tax rate for social security is 6.2% for the employer and 6.2% for the employee, or 12.4% total. The current rate for Medicare is 1.45% for the employer and 1.45% for the employee, or 2.9% total.

Combined, the FICA tax rate is 15.3% of the employee's income.

These taxes are deducted from an employee's income at 7.65 per cent, which is split into the following percentages:

• Medicare taxes – 1.45%
• Social Security taxes – 6.2%

These figures are deducted from an employee's gross pay for each paystub. So, if an employee earns a gross income of $1,000, he would need to pay $62 as Social Security tax and $14.50 in Medicare tax.

How to Calculate Federal Income Taxes

There are two main ways to calculate federal income tax withholdings. The IRS allows employers to choose which method they prefer and provides tables to help them determine withholding amounts. These methods are:

1. The Wage Bracket Method
2. The Percentage Method

1. Wage Bracket Method

The wage bracket method is the easiest and most straightforward approach of the two, as the employer can determine the exact amount to withhold based on the employee's taxable wages, marital status, number of allowances and payroll period. However, this method stops at 10 allowances and limits the number of incomes that can be used to calculate withholding.

The employer can check the tax and other deductibles by looking at specific tables instead of doing any actual math. These 2019 tables are found on pages 48-67 of the IRS' Publication 15. To figure out which right chart to choose, you need to identify two factors:

• Whether you are filing as single or married
• The frequency of the income - if it is paid out as daily, weekly or monthly wages.

With this information, you need to select the right chart and ascertain the withholdings by lining up how much an employee made in a payroll period along with the number of withholding exemptions that your employees claimed on their W 4 forms. For example, a married employee who earned $1,000 on a weekly pay period and claimed two withholding allowances would have $66 in federal income tax withheld from his or her paystub.

1. Percentage Method

This is a slightly complicated wage method and requires some calculations. The first step is to multiply an employee's total number of withholding allowances by the allowance amount associated with your specific payroll period. 

• Weekly – $80.80
• Biweekly – $161.50
• Semi-monthly – $175
• Quarterly – $1,050
• Semi-annually – $2,100
• Annually – $4,200
• Daily (for each day of a payroll period) – $16.20

Once you multiply the number of allowances by the associated allowance amount, you will then subtract that total from the employee's taxable wages for that pay period. Let us understand this by going back to the wage bracket example of that married employee who makes $1,000 per week and claimed two exemptions. You would multiply the weekly amount ($80.80) by two, which results in a total of $161.60. That total is subtracted from $1,000, which leaves you with $838.40. 

Now that you have the total amount subject to income tax withholding, you need to refer to the percentage method tables on pages 46-47 of Publication 15 to determine the estimated withholdings. The process here can be tricky. You'll need to find the chart that aligns with your employee's pay period and marriage status. 

Our total salary subject to withholdings is $838.40, so the amount of income tax to withhold is $37.30 plus 12 % of the amount over $600. This means that we will need to subtract $600 from $838.40, which leaves us with $238.40. We can now determine 12 % of that amount, which leaves us with $28.608. Add that to the $37.30 stipulated in the chart, and the total federal income tax withholdings for the example employee is $65.908, which is rounded to $65.91. 

The IRS also allows you to round withholdings to the nearest whole dollar, which would make our example withholdings $66, which is the same amount as we found through the wage bracket method.

How to Calculate State and Local Income Taxes

Unlike federal income taxes, each state has its own set of rules regarding the taxes to be deducted from your employees' pay stubs. Some states such as Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not impose income taxes on its citizens. 

On the other hand, there are several states, including Ohio and Michigan, among others, require you to withhold both state and local income taxes. Different states have multiple tax brackets to derive the right deduction amounts for each paystub. To determine how to calculate these taxes – if there are any – you will need to consult your state government's site for exact details. You could use a datasheet with all the 2019 state individual income tax rates and brackets for reference.

The Importance of Proper Payroll Management

Managing the payroll and the associated complicated tax rules and calculations become a massive challenge for most businesses. In a survey conducted by QuickBooks Payroll, almost 79% of small business owners say they find it hard to stay on top of the payroll tax, due to the multiple calculations and various regulations.

Of the employers who process the payroll tax on their own, 44% people found it confusing, 47% said it was complicated, and 49% mentioned it as frustrating, and that manual processes were leading to more mistakes. As a result, 1 in 4 of the businesses in the survey has come under the scrutiny of the IRS.

With so much pressure, businesses are increasingly adopting professional software to streamline their payroll process and ensure compliance. Deskera offers an efficient payroll software solution to automate the entire end-to-end process of generation, distribution and record keeping of pay stubs. Contact us for more details.