Step-by-Step: How to Do Payroll Manually (plus, how to manually calculate payroll taxes)

Starting a small business brings its own financial challenges, especially in managing payroll. Our goal is to simplify the payroll and deduction process, making this topic more accessible for new entrepreneurs. This guide is crafted to present payroll management in straightforward, easy-to-follow steps, avoiding complicated financial terms. In the article we will explore how to manually calculate payroll, including how to manually calculate payroll taxes and deductions, specifically for small business.

Table of Contents

Disclaimer: The information provided here is for general informational purposes only and should not be considered as professional tax advice. We are not certified tax professionals or legal advisors. Therefore, we strongly recommend consulting with a qualified tax professional or legal advisor to obtain advice tailored to your specific situation and to ensure compliance with all applicable tax laws and regulations.

Understanding Payroll Basics

Before diving into how to do payroll manually, it’s important to grasp some basic payroll concepts:

  • Gross Pay: The total amount you owe an employee before any deductions are made.
  • Net Pay: The amount an employee takes home after all deductions.
  • Deductions: Amounts subtracted from an employee’s gross pay, including taxes, benefits, and any other withholdings.

Additionally, you’ll need to be aware of your legal obligations, such as submitting payroll taxes and compliance with state and federal regulations.

Setting Up Your Manual Payroll System

Before you can process any payments, you’ll want a structured payroll system in place, which we will explain in the steps below. More so, understanding the “why” behind each step helps provide additional context for new or aspirational business owners.

Obtain an Employer Identification Number (EIN)

First things first, if you haven’t already, apply for an EIN through the IRS website. It’s free and necessary for reporting taxes and other documents to the Internal Revenue Service (IRS).

Why: An EIN is essentially your business’s social security number. It’s required for reporting taxes and other documents to the IRS. An EIN is unique to your business and is used to identify your business for federal tax filing purposes. Without it, you can’t legally pay your employees or file business tax returns.

Decide on a Payroll Schedule

Choose how often you’ll pay your employees: weekly, bi-weekly, semi-monthly, or monthly. Consider state laws, as some states mandate the minimum frequency of payments.

Why: Establishing a consistent payroll schedule helps anticipate cash flow. It also sets clear expectations for employees regarding when they will be paid.

Set Up Employee Records

For each employee, you need to maintain a detailed record that includes:

  • Personal information (name, address, Social Security number)
  • Tax withholding information (from W-4 forms in the U.S.)
  • Pay rate (hourly or salary)
  • Payroll schedule (e.g., bi-weekly)
  • Start date of employment

Why: Accurate employee records better enable you as an employer to contact employees, comply with tax withholding requirements, and calculate pay accurately. Additionally, these records are essential for legal compliance, audit readiness, and efficient management of benefits and deductions (don’t worry, we’ll get to that soon).

Collect and Review Timekeeping Data

If you have hourly employees, you’ll want a reliable method to collect and review time worked. This can be as simple as a spreadsheet or a time clock. Ensure the accuracy of the hours worked to avoid discrepancies in pay.

Why: For hourly employees, accurate timekeeping is fundamental to calculating correct wages. Errors in time tracking can lead to under or overpayment, affecting employee satisfaction and potentially resulting in legal issues. Efficient timekeeping practices ensure fair compensation and compliance with labor laws.

Understand and Keep Up with Tax Requirements

Familiarize yourself with the current tax rates for Social Security, Medicare, and federal and state income taxes. These rates can change, so it’s important to stay updated to ensure accurate deductions.

Why: Tax rates change. Staying informed and applying the correct rates helps you withhold the right amount from employee paychecks, avoiding potential penalties for underpayment and ensuring compliance with tax laws.

Determine Benefit Deductions

If you offer benefits like health insurance or retirement plans, you’ll need to calculate these deductions for each payroll period. Keep track of any changes in employee enrollment in these benefits.

Why: Proper calculation and deduction of benefits are vital for maintaining the accuracy of payroll and for fulfilling your obligations as an employer offering benefits. Mismanagement can lead to financial discrepancies and more obviously, affect employee satisfaction.

Create a Payroll Ledger (like a spreadsheet)

A payroll ledger is an essential tool for manually processing payroll. This can be a spreadsheet where you track each employee’s gross pay, deductions, and net pay for each pay period. You’ll use this ledger to issue payments and for year-end reporting.

Why: A detailed payroll ledger, or spreadsheet (if you’re not feeling fancy) helps you track each pay period’s financial activities, including gross pay, deductions, and net pay. This record is crucial for financial planning, tax filing, and resolving any discrepancies that may arise. It also serves as a historical document for auditing purposes.

Establish a System for Payroll Record Keeping

You’re required by law to keep payroll records for a certain number of years (the IRS requires at least 4 years). Decide on a filing system, whether digital or physical, to organize payroll records, tax forms, and employee documentation.

Why: Keeping payroll records is not only a legal requirement but also a best practice for any business. It allows you to respond to inquiries from employees or tax authorities accurately and efficiently. Good record-keeping practices help maintain requirements and facilitate easier management of payroll over time.

Prepare for Payroll Taxes

Set aside the total amount of payroll taxes you’ve withheld from employees. You’ll need to pay these to the IRS and state tax agency according to their payment schedules.

Why: Setting aside funds for payroll taxes ensures that you have the necessary cash on hand to meet tax obligations on time. Timely tax payments avoid penalties and interest charges, helping to maintain your business’s financial health and compliance status.

Disclaimer: The information provided here is for general informational purposes only and should not be considered as professional tax advice. Therefore, we strongly recommend consulting with a qualified tax professional or legal advisor.

Develop a Process for Issuing Payments

Decide whether you’ll be issuing payments by check or setting up direct deposits. If issuing checks, ensure you have a secure method for writing and distributing them. For direct deposits, you may require authorization from your employees to set up arrangements with your bank.

Why: Deciding on a payment method and establishing a secure, efficient process is key to ensuring employees are paid on time and in a manner that meets their needs. Whether through checks or direct deposit, a smooth payment process reduces administrative stress and enhances employee satisfaction.

Stay Informed on Compliance Changes

Payroll regulations can change due to new laws or policy updates. Stay informed by subscribing to updates from the IRS, your state tax agency, and any relevant labor departments.

Why: Labor laws, tax rates, and reporting requirements can change due to legislative updates or policy shifts. Staying informed allows you to adjust your payroll processes accordingly, avoiding potential legal and financial penalties.

How to Calculate Payroll Manually

The following scenario provides a detailed view into the complexities of manual payroll calculation, highlighting the need for accuracy and attention to detail, especially with varying employee types and deduction requirements.

Step 1: Calculate Gross Pay

First, you need to figure out how much each of your employees has earned before any deductions are made.

  • John Doe: An hourly employee who earns $25/hour and worked 90 hours in the pay period.
  • Jane Smith: A salaried employee with an annual salary of $60,000. The business has bi-weekly pay periods (26 per year).

For John (Hourly Employee):

  • Scenario: John worked 90 hours this pay period. His regular rate is $25/hour for the first 80 hours, and he gets time-and-a-half for the 10 hours of overtime.
  • Regular Pay: 80 hours * $25/hour = $2,000
  • Overtime Pay: 10 hours * ($25/hour * 1.5) = $375
  • John’s Gross Pay: $2,000 + $375 = $2,375

For Jane (Salaried Employee):

  • Scenario: Jane’s on a salary, so her pay is more straightforward. She earns $60,000 a year, and we have 26 pay periods.
  • Regular Pay: $60,000 / 26 = $2,307.69
  • Bonus Pay: She also received a $1,000 performance bonus this period.
  • Jane’s Gross Pay: $2,307.69 + $1,000 = $3,307.69

Step 2: How to Calculate Payroll Deductions Manually:

Assume the federal tax rate is 10%, state tax is 5%, Social Security is 6.2% on the first $142,800 of earnings, and Medicare is 1.45%. The 401(k) contribution rate is 5%, and health insurance is $200 per pay period.

John’s Deductions:

  • Federal Tax: $2,375 * 10% = $237.50
  • State Tax: $2,375 * 5% = $118.75
  • Social Security: $2,375 * 6.2% = $147.25
  • Medicare: $2,375 * 1.45% = $34.44
  • 401(k): $2,375 * 5% = $118.75
  • Health Insurance: $200
  • Total Deductions: $856.69

Jane’s Deductions:

  • Federal Tax: $3,307.69 * 10% = $330.77
  • State Tax: $3,307.69 * 5% = $165.38
  • Social Security: $3,307.69 * 6.2% = $205.08
  • Medicare: $3,307.69 * 1.45% = $47.96
  • 401(k): $3,307.69 * 5% = $165.38
  • Health Insurance: $200
  • Total Deductions: $1,114.57

Step 3: How to Calculate Net Pay

After figuring out each deduction, subtract them from the gross pay to find out the net pay, which is what John and Jane will actually take home.

John’s Net Pay:

  • $2,375 – $856.69 = $1,518.31

Jane’s Net Pay:

  • $3,307.69 – $1,114.57 = $2,193.12

Payroll Reporting and Compliance

Now, It’s Your Turn

Processing payroll manually might seem complex, but breaking it down into manageable steps can make it more approachable. Remember, this guide is just the beginning. As your business grows, you may want to explore software services to streamline your payroll process.

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