If you’ve been in business for a while, you know that an employee’s salary doesn’t end with the amount of money that they take home. For an employer, it’s only a part of the overall expense, as the employee’s annual salary is actually higher than what the worker receives in cash.
And if you’re an employee, you may feel confused after seeing a different sum at the bottom of your employee’s pay statement. Your take-home pay is lower than the sum you’ve agreed upon with your employer when you first started working for them - the sum you see at the top of the pay stub.
Here’s where the difference comes from: the higher number represents an employee’s gross pay, while the lower one is the net pay.
In this article, we’ll explain what exactly these two types of pay are and how you can calculate gross pay and net pay for different kinds of contracts.
What is gross pay?
Simply put, gross pay is the total amount of money an employee earns in a year before any deductions and taxes are removed. That’s the number you agree upon when signing a contract, and the employee sees it as the highest number on their pay stub. It’s also the total amount of money an employer pays for an employee.
Pay your team effortlessly with mass payments
Pay your global team in a one click, with mass payments. We support payroll in over 120 currencies with flexible payment methods.Learn more
What is net pay?
An employee’s net pay is what you actually earn after the deductions and taxes are taken out. These include income tax, Medicare, Social Security, and other fees. After these deductions and taxes have been removed from your gross wages, you see a lower amount of money in your bank accounts on each payday, which is your net income.
Gross pay vs. net pay in practice
Let’s give a few examples to illustrate the point.
For instance, you’ve agreed to an $18 hourly wage. If you work 20 hours a week, that means your gross annual salary is around $17,280, depending on the number of hours spent working. You may also agree upon an annual salary with your employer - for example, $40,000 a year. In that case, your gross income is $40,000, but it’s not what you’ll earn as net pay in a year.
It’s worth mentioning that an employer can’t offer a smaller wage than the federal minimum wage, which is $7.25 per hour for the majority of the workforce. Note that this is the law in most states, but some may have their own minimum hourly rate. For example, the minimum hourly wage in Florida is $8.65, $12 in Connecticut, $12.15 in Maine, etc.
Be aware that the way to calculate gross and net income for each employee may differ depending on their individual case. As different factors impact the federal income tax withholding, two people may have the same gross earnings but different net income.
If you’re an employee, you can also see your net pay in your pay statement. It’s usually in bold letters or emphasized in some other way to make it easier to identify.
What is removed from the gross pay?
There are two types of gross pay deductions: mandatory and optional.
Gross pay mandatory deductions
Taxes and Federal Insurance Contributions Act (FICA) deductions are part of mandatory payments removed from an employee’s gross salary. An employee can’t choose if they want these deductions to be made or not.
FICA deductions refer to health insurance and Social Security and they’re deducted from each paycheck an employee receives. In 2021, the Social Security tax is 6.2%, while Medicare tax is 1.45%. Some employees, who earn over $200,000 or $250,000 a year (depending on whether they’re filing for taxes as singles or jointly), have an additional 0.9% of Medicare tax.
Employees and employers work together to make sure the correct amount of taxes and deductions is withdrawn from the employee’s gross income. Employees are required by the IRS to complete the Form W-4 where they provide all the important information the employer needs to calculate how much money should be withheld.
Gross pay mandatory wage garnishments
Another type of mandatory deductions is mandatory wage garnishments that are legally withdrawn from an employee’s gross income if they’ve been in a lawsuit and they’ve lost. In this case, the employer is in charge of transferring the designated amount of money to the person or an institution that won.
Examples of these wage garnishments are child support, tax debt, fines or restitution ordered by the court, and student loan repayment. These garnishments are legal even in the four states where wage garnishments are not allowed - Pennsylvania, North Carolina, South Carolina, and Texas.
Garnishments in other states are also possible for different default payments, such as medical debt.
Gross pay optional deductions
Optional, or voluntary, deductions include benefits an employer may offer to their employees. The employees willingly choose to deduct an amount of money from their paychecks for specific purposes, that go from credit repayment support to vacation savings plans. Some examples of voluntary deductions are retirement contributions, flexible savings accounts, life insurance, health insurance premiums, union due, equipment costs, even qualified tuition programs that some people use to save money for their children’s education.
To put some of the voluntary deductions into practice, you need to have a written agreement with your employee.
For example, even though the ACA (Affordable Care Act) mandate has been canceled, an employer with more than 50 employees who work full time needs to offer this type of health coverage to their staff. However, the employees can opt to decline or accept it.
How does the Form W-4 help with calculating the gross vs. net pay?
It’s an employee’s obligation to submit a properly filled-in Form W-4 at least once per year. If an employee fails to do so, as an employer, you simply continue using the latest Form W-4 they’ve submitted regardless of potential changes in the employee’s marital status or other factors.
To ensure that the taxes and deductions have been made correctly, the employees should submit this form regularly, and each time there’s been a change that can affect their tax rates and net income.
Gross income vs. net income in business
If you’re a small business owner, you may also use this terminology. In business, gross profit and net profit are more commonly used terms to designate different types of income.
Gross profit in business is the amount of revenue that’s left after the cost of your product or service is removed. On the other hand, net profit is what’s left after you remove the operating expenses, too.
How to calculate gross income for an hourly employee?
Both hourly and salaried employees have a way to calculate their gross income. However, the methods differ based on how you’re paid.
If you have an hourly wage instead of a salary, it may be difficult to calculate in advance how much you’ll work in a year. However, you can do it when a tax year ends - you can gather all your pay statements and calculate the gross income for the whole year.
If your contract guarantees a specific number of hours throughout a year, you may be able to calculate your gross pay in advance, at least approximately.
The formula is simple:
Your hourly rate x the number of hours you’ve worked in a week
This result represents your weekly earning, which you can then multiply by four to get your monthly income. To calculate your gross annual income, multiply your monthly pay by 12, which is the number of pay periods in a year if you get monthly paychecks. If your pay period is semi-monthly, multiply your weekly pay by 24. For biweekly payments, multiply by 26.
If we use the numbers from the sections above, we get these numbers:
An hourly wage of $18, multiplied by 20 hours a week is $360 per week. This pay equals $1,440 per month, which is $17,280 a year.
However, be careful when calculating your gross pay in advance as there are different situations that may affect your gross income to take into account. Your pay rate may increase over time if you get a raise. On the other hand, you may take some time off and your employer doesn’t offer paid days off.
How to calculate gross income for a salaried employee?
Salaried employees may have an easier task here. They have a more predictable income and, what’s more, they have their gross annual pay in the contract.
However, if you’ve received bonuses or other types of payments from your employer, you may want to calculate your total income manually. You’ll also need to add these compensations to your gross salary because there may be a different tax rate for them.
Whether or not you have a bonus to add, calculating your gross income is simple when you’re a salaried employee.
- If you get paid monthly, multiply your income by 12.
- If you get paid semi-monthly, multiply your income by 24.
- If you get paid biweekly, multiply your income by 26.
- If you get paid weekly, multiply your income by 52.
You can also use an inverted formula to calculate your gross income per payroll if you’re not sure. For example, if your annual gross salary is $60,000, divide that number by the number of pay periods in a year. If you get paid monthly, it’ll be $5,000 before tax deductions.
How to calculate payroll taxes?
In this section, you can learn how to calculate payroll taxes and what payroll deductions need to be made to calculate their net income.
Federal Income Tax
There isn’t a unique formula to calculate your employee’s federal income tax because it depends on several factors. For instance, you need to know their filing status (if they’re filing as a single person or jointly with their spouse) and if they have additional income to report.
However, when an employee fills in the Form W-4 appropriately, calculating their federal income tax isn’t complicated.
FICA payroll tax
The total amount of FICA payroll tax is 15.3%. This payment is divided between the employer and the employee - the employee pays their half through their income deductions. The FICA tax is deducted from the employee’s taxable income (after you deduct, for example, the retirement contribution pay, and make other potential pre-tax deductions).
Note that the Social Security tax isn’t deducted from gross salaries over $132,900.
When you’re done with deducting the federal income tax and FICA payroll tax, it’s time to remove any mandatory wage garnishments your employee may have, and you get the employee’s net income.
FUTA payroll tax
There’s another type of tax an employer pays, and it’s used for the unemployment benefits program. The Federal Unemployment Tax provides compensation for those who have lost their jobs, and every employer pays 6% on the first $7,000 of each employee’s gross income.
Disclaimer: This article is for informational purposes and does not constitute legal, tax, or any other advice. Always check the official Internal Revenue Service website for more information.