Payroll accounting is how a business records employee compensation and keeps track of amounts that are withheld from employees’ paychecks for taxes and benefit plans. Keeping detailed records of the employer’s share of payroll taxes and employee benefit programs is also a key component of how to do payroll accounting.
Since multiple laws come into play with payroll taxes and benefits, payroll accounting can be a complex and time consuming process. In this article, we will break things down for you and tell you what you need to know to optimize your payroll process, including the following:
- What Payroll Accounting Is, and What You Have to Track
- Set Up Your Company to Hire Employees
- Gather Paperwork You Need to Pay Employees
- How to Calculate Paychecks
- How to Record Payroll
- How & When to Report and Pay your Payroll Taxes
- How to Manually Calculate Payroll Checks
Make payroll a breeze by using our recommended payroll software Gusto. Gusto offers integrations with QuickBooks, time tracking software, and more to keep everything you need to do payroll in one easy-to-use platform. Try it free for a month.
How to Do Payroll Accounting: What Is It and What Do You Have to Track?
Payroll accounting involves keeping detailed records of all the following:
- Gross wages, salary, bonuses, and other taxable income earned by employees
- Amounts withheld from employee compensation for federal income tax, social security tax, and medicare taxes
- Amounts withheld from employee compensation for health benefits, retirement benefits, or wage garnishments
- As an employer, your portion of social security, medicare, and unemployment taxes
- Employer portion of health insurance, retirement plan, sick leave pay, and vacation pay along with other fringe benefits you offer to employees.
First, we’ll cover the steps that you need to take to be able to hire employees:
Step 1. Set Up Your Company to Hire Employees
Here are the primary items you’ll need to track all of the information above and start paying employees:
Get an Employer Federal Employer Identification Number (EIN)
The Federal government tracks all tax payments made by a business using their EIN (Employer Identification Number). It’s free to get an EIN from the IRS. You can find out how to get started here.
Decide on Wage & Salary Types
You’ll need to decide salary levels for all your employees and whether you’ll be paying employees hourly or with an annual salary.
Select Pay Periods
It is important to establish how often you will pay employees before you hire them. The most common pay periods used are weekly, biweekly, semimonthly and monthly.
Decide What Benefits You Will Offer to Employees
Benefits are a key component of payroll. For example, if you offer a 401K plan or a health insurance, plan then you must decide how much you will contribute as an employer and what the employee must contribute in order to participate in the plan. For more info on how to determine which benefits to offer employees, check out Employee Benefits: The Ultimate Guide.
Purchase Workers’ Comp Insurance
Workers compensation provides protection for employees who are injured on the job or become sick because of the job. Workers’ compensation is mandated by each state except Texas. You can learn more about the cost, state requirements, and how to purchase workers’ comp here.
Step 2. Gather Paperwork You Need to Pay Employees
After hiring your employees, you’ll need to set up your employees in your payroll system. For each employees, you will typically need an I-9 form, W-4 form, and direct deposit authorization form, if applicable. Below you will find a brief description of each of these forms.
All employers in the U.S. must verify that any person they plan to hire is a U.S. citizen or has the right to work in the United States. This must be done by completing the I-9 form and making copies of documentation provided by the employee such as social security card, VISA, birth certificate or driver’s license. Click here to download a sample I-9 form.
On this form, employees will provide information like their marital status and the number of allowances they want to take for their dependent children. Based on this information, you can calculate how much income taxes to take out of your employees’ paychecks. Employees can fill out a new W-4 form anytime their status changes.
Direct Deposit Authorization Form
If you offer direct deposit to your employees, you must get their permission to deposit money into their bank account. To do so, you need to have each employee complete a direct deposit authorization form. In addition, have the employee submit a voided check along with the completed form. This will allow you to verify that they have given you the correct bank routing and account number. Click here to download a sample direct deposit authorization form.
In my experience, you should only allow employees to deposit into one bank account. Otherwise, you will find yourself managing your employee’s money if you allow them to split their check to multiple bank accounts.
Paying employees via direct deposit will allow you to save money because you don’t have to purchase check stock. On the other hand, if you make a mistake in calculating an employee’s pay, it is much easier to void a payroll check and reissue it. Unfortunately, you can’t void a direct deposit payment. Once it is made, you will have to work with the employee to either issue them a check if you underpaid them or reduce the employee’s next direct deposit payment.
If you can’t get all of your employees to sign up for direct deposit, then you will need to print payroll checks. Printing payroll checks in payroll software like Gusto is quick and easy. All you have to do is purchase payroll check stock.
Step 3. How to Calculate Paychecks
Now that we have covered what you need to do to prepare yourself to pay employees, the next few sections will cover the steps involved to pay employees, recording payroll on the books, and paying and filing payroll taxes.
Before we get into the nitty gritty of calculating paychecks, I must tell you that I don’t recommend manually calculating paychecks. First, the calculation can get very complicated which makes it easy to make a mistake. Second, any mistake that you make could result in an under or overpayment to your employee or an under or overpayment to state, federal, and local authorities. I don’t have to tell you that miscalculating paychecks will not be an acceptable excuse to give the IRS if it results in an underpayment of payroll taxes.
Make things easier on yourself by using a payroll software like Gusto. To calculate paychecks in Gusto, all you have to do is enter the number of hours worked for each employee and provide any sick or vacation days taken. Based on this info, Gusto will automatically calculate paychecks for you!
Don’t worry, if you’re dying to know how to manually calculate paychecks, we will cover that in detail in the How to Manually Calculate Payroll Checks section so keep reading.
Step 4. How to Record Payroll
Before you can record payroll, you will need to set up payroll accounts on your chart of accounts list. The chart of accounts is a list of accounts that is used to categorize the financial transactions that your business generates.
One of the many benefits of using Gusto is you can connect your QuickBooks account to Gusto and map your chart of accounts within Gusto so that each time you run payroll, all of the accounts are updated in real time!
Chart of Accounts Setup
The accounts that you need to set up to track payroll will generally be an expense account or a liability account. An expense is a cost that you have as a result of doing business like gross wages and health insurance. A liability is money that you owe to others. For example, workers compensation is a liability because it is money owed to your insurance provider and employee health insurance is an expense because it will be paid to the vendor that provides health insurance benefits for your business.
Below is a list of the accounts you will generally need to set up on your chart of accounts to track all payroll-related activities. Below this list is a brief description of each account.
|Account Name||Account Type|
|Health Insurance (Employer Share)||Expense|
|State Disability Payable||Liability|
|Employee Health Insurance Payable||Liability|
|401K Employee Contribution||Liability|
|Accrued Vacation Payable||Liability|
|Accrued Sick Payable||Liability|
- Gross Wages – For this account, you will include the amount that you pay to an employee every pay period before any deductions are made.
- Health Insurance – In this account, you will include the total amount of health insurance that you pay to your insurance provider (i.e. Blue Cross, Kaiser, etc.).
- 401K Matching – If you offer a 401K plan to your employees, you will include the amount of contributions you have made to match your employee contributions in this account. This money will be paid to the investment company that is responsible for maintaining the company 401K. (i.e. Fidelity)
- Federal Withholding – This account should reflect the total amount of income taxes you have withheld from all employee paychecks. You will remit these funds to the IRS based the deadlines set by the IRS. Refer to the reporting requirements section for more info.
- FICA Payable – Deductions from employee paychecks for social security and medicare taxes will accumulate in this account. You will remit these funds to the IRS based the deadlines set by the IRS. Refer to the reporting requirements section for more info.
- SUTA Payable – This account should include the state unemployment taxes that you are responsible for paying. Refer to the State and Local Requirements section for more info.
- State Disability – This account should include the state disability taxes that you have withheld from employees, if applicable. Read on to the State and Local Requirements section to learn more.
- Workers Compensation – In this account, you need to reflect the amount of workers compensation due. To learn more about how to calculate workers compensation, click here.
- Employee Health Insurance Payable – This account will include the amount withheld from employee paychecks for health insurance coverage. This account will reduce the amount of health insurance paid by the employer. To learn more about offering health insurance, click here.
- 401K Employee Contribution – All employee 401K contributions withheld from paychecks will accumulate in this account. This money will be paid to the investment company that is responsible for maintaining the company 401K. (i.e. Fidelity)
- Accrued Vacation Pay – If you offer your employees time off with pay, then you need to keep track of the amount of time they have earned on the books. The way this would work is an employee would earn a certain number of vacation hours each pay period. It is important to record accrued vacation because it is money that you owe to the employee. If he/she were to quit or you fired them then you would have to include all accrued vacation pay in their final paycheck. Let’s take a look at an example to see how this would work. Looking to learn more about vacation and PTO? Click here.
Example of Accrued Vacation
Let’s say an employee gets 10 vacation days each year and is on a biweekly pay period. You would calculate the number of vacation hours this employee would accrue each pay period as follows:
10 vacation days X 8 hours = 80 hours (this is the amount of vacation hours earned each year)
80 hours/26 weeks (number of times a biweekly employee is paid each year) = 3.08 hours (this is the number of vacation hours earned each pay period)
To accrue vacation on the books, you must use a journal entry. A journal entry is a manual way to record business transactions. It generally will include an effective date, a debit amount, and a credit amount. To learn more about what a journal entry is and how to create one, check this out. Below is an example of the journal entry we would record for this employee if he earned a wage of $30 per hour.
|Debit||Gross Wage Expense||$92.50|
- Accrued Sick Pay – Similar to accrued vacation pay, you need to keep track of the amount of sick pay an employee has earned on the books. You can establish how much sick pay an employee would earn per pay period (as we did in the above accrued vacation pay example).
Let’s assume this employee has earned 1 hour of sick pay at a $30 per hour wage then our journal entry would be as follows:
|Debit||Gross Wage Expense||$30.00|
Journal Entry to Record Payroll
As discussed in the previous section, a journal entry is best described as the recording of debits and credits. If you use an accounting program like QuickBooks, you don’t have to enter journal entries often because QuickBooks does that for you “behind the scenes” when you create an invoice for a customer or pay a bill. However, if you use a manual accounting system, then you will need to create journal entries.
When you record payroll, you will generally debit Gross Wage Expense, credit all of the liability accounts, and credit the cash account. Gross Wages will appear on your Profit and Loss report, and the liability and cash accounts will be included on your Balance Sheet report.
Here is an example of a journal entry for a $10,000 payroll:
|Debit||Gross Wage Expense||$10,000|
|Credit||Employee Health Insurance||$1,000|
|Credit||401K Employee Contribution||$2,000|
If you don’t want to manually record a journal entry every week or however often you run your payroll, you should use Gusto. Gusto easily integrates with QuickBooks so that each time you run payroll, Gusto will automatically sync with QuickBooks. All of the debits and credits are recorded for you behind the scenes!
Step 5. File & Pay Payroll Taxes
There are many payroll reporting requirements at the federal, state, and local levels. We will focus on what the federal government requires. However, in the next section, you will find a couple of great resources that you can use to research what the requirements are for your particular state and local area.
There are four main tax forms that you are required to complete in order to report your payroll tax information. Below is a summary table of each tax form, their respective due dates, and a description of the tax reported on each form.
Payroll Tax Forms & Due Dates Table
|Tax Form||Due Date|
|Form 941||1 month after a quarter ends. (i.e. April 30, July 31, Oct 31 and Jan 31)|
|Form 940||Annually on Jan 31 for the preceding tax year|
|W-2 Form||Must be filed electronically with the SSA (Social Security Administration) office by
Jan 31 for the preceding year.
Must be mailed to employee no later than
Jan 31 for the preceding tax year.
|W-3 Form||Must be filed electronically with the SSA (Social Security Administration) office by
Jan 31 for the preceding year.
Use this form to report the total social security and medicare taxes (FICA) withheld from all employee paychecks plus the employer share of social security and medicare tax. Social security is 12.4% of employee wages up to a maximum salary of $127,200. Medicare is 2.9%, with no salary cap.
While you must file Form 941 on a quarterly basis, you may be required to submit payments to the IRS either on a monthly or semimonthly basis. For more info on when to pay FICA taxes and how to file Form 941, click here.
Under the Federal Unemployment Tax Act (FUTA), employers have to pay a tax rate of 6% on the first $7,000 that each employee earns. Form 940 must be filed annually to report payments made for unemployment taxes. While you only have to file this form annually, you may be required to submit payments more often than that. For more information on when to pay FUTA taxes and how to file Form 940, click here.
This form provides employees with a summary of the wages that you paid them and the deductions taken for the tax year. You are required to provide all employees with this form by the due date. You must also file this form with the SSA (Social Security Administration). It is recommended that you electronically file this form. To learn more about how to file electronically, check this out.
This form is a summary of all W2 forms issued to employees, You must also file this form with the SSA along with all W2 forms. This form should be filed electronically with the SSA at the same time that you file form W2.
How to Manually Calculate Payroll Checks
For the vast majority of small business owners, payroll software like Gusto is going to be a huge time saver for calculating paychecks. However, I do believe that it is important for you to understand what goes into calculating payroll checks in case you ever need to do it manually or correct a payroll error. Let’s walk through the components of the formula and then use an example so that you can see how to do the calculation.
Here is the formula to calculate net pay for an employee along with a brief description of each component.
Net Pay = Employee gross pay minus (Employee share of Social Security + Medicare + Federal withholding tax + Other Deductions)
Gross pay is the salary/wage paid to an employee each pay period. The formula to calculate gross pay for hourly and salary employees is as follows:
- Hourly employee: Hours worked x Hourly Rate
- Salary employee: Annual salary/ Total # of pay periods
Social Security Tax
As an employer, you are required to withhold 6.2% of an employee’s gross pay for social security. You are also required to match the 6.2% employee contribution. Here is the formula to calculate the employee’s share of social security taxes:
- Gross pay x 0.062
You are required to withhold 1.45% of an employee’s gross pay for the medicare fund. Similar to social security, you are required to match the 1.45% employee contribution. Here is the formula to calculate the employee’s share of medicare taxes:
- Gross pay x 0.0145
Federal withholding is the amount of income tax that an employee must pay, based on their gross pay, tax bracket, the number of allowances claimed on Form W-4, and their marital status. With this information, you can look up the federal withholding amount for employees by using the IRS Tables in Pub 15. To see how this works, let’s walk through an example.
In this example, let’s assume our employee is married and has claimed 2 allowances on her W4 form. She is paid $1,600 per pay period. Assuming we run payroll on a biweekly basis, we would use the following wage bracket table (from IRS Pub 15) to determine the amount of income tax to withhold. Based on this table, we would withhold $109 from this employee’s paycheck for income tax.
Depending on what fringe benefits you offer, there may be several deductions that you need to make for employee paychecks besides social security, medicare, and federal withholding. For example, if you offer a health insurance plan that the employee can contribute to, you will need to deduct the employee’s share of that health insurance plan in order to calculate net pay.
Putting It All Together
Now that you are more familiar with the components of calculating next pay for your employees, let’s walk through an example.
Let’s assume this employee makes $20/hr and worked 80 hours this pay period.
|Step 1: Calculate Gross Wages||80 hours X $20 = $1600|
|Step 2: Calculate Federal Income Tax Withholding|
(from previous example)
|Step 3: Calculate Social Security Tax||$1,600 X 0.062 (6.2%) = $99.20|
|Step 4: Calculate Medicare Tax||$1,600 X 0.0145 = $23.20|
|Step 5: Subtotal all deductions|
(steps 2, 3, 4)
|$109 + $99.20 + $23.30 = $231.50|
|Step 6: Subtract subtotal of all deductions from Gross Pay to get Net Pay||$1,600 - $231.50 = $1,368.50 (Net Pay)|
State and Local Requirements
In this article, we have primarily focused on your tax responsibility at the federal level. However, states and localities may have additional or different laws when it comes to payroll taxes. To learn more about your tax responsibility at the state level, consult your state tax website.
The Bottom Line
If you are a bit overwhelmed by how to do payroll accounting, you are not alone. Many business owners use payroll software like Gusto to take care of their payroll needs. As we mentioned previously, Gusto can save you a TON of time by automating manual tasks like calculating your paychecks, computing your share of social security tax, medicare tax and state and federal unemployment taxes.
Filing your payroll tax returns is a piece of cake with Gusto because it will automatically transfer your payroll data to each tax form for you! Finally, if you use QuickBooks then the integration with Gusto will allow you to have financial statements that will always be updated with the latest payroll data.