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Understanding Payroll Processing Basics

Payroll processing is the system businesses use to pay their employees accurately and on time. It involves calculating wages based on hours worked, deducting taxes and other withholdings, and distributing paychecks or direct deposits. For small business owners and managers, understanding how payroll works is critical to running a compliant, efficient operation.

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The payroll process typically includes several key steps. First, you collect information about each employee's hours worked, pay rate, and personal tax information. Then you calculate gross pay—the total amount earned before any deductions. Next, you determine what must be withheld from paychecks, including federal income tax, Social Security tax, Medicare tax, and any state or local taxes depending on where your business operates. After calculating net pay (what employees actually receive), you record these amounts in your accounting system and distribute the paychecks.

Many business owners don't realize that payroll has serious legal requirements attached to it. Federal law requires you to withhold and pay certain taxes on behalf of your employees. You must also file reports with the IRS and state agencies showing what you've withheld and paid. Missing these obligations can result in penalties, fines, and legal consequences. This is why payroll mistakes can be costly—not just in terms of money, but also in potential compliance issues.

A free informational guide about payroll processing typically covers how each of these steps works in practice. The guide explains why certain deductions are required, what records you need to keep, and how the timeline for paying employees and filing taxes works throughout the year. This foundational knowledge helps business owners understand what's involved in payroll, whether they handle it themselves or hire someone to do it.

Practical Takeaway: Before you set up any payroll system, understand that payroll involves three main phases: collecting employee information and hours, calculating deductions and net pay, and filing reports with government agencies. This overview helps you identify where you need support or additional training.

Tax Withholding Requirements You Must Follow

Tax withholding is one of the most important aspects of payroll, and it's not optional. When you employ someone, you are legally required to withhold federal income tax, Social Security tax (6.2%), and Medicare tax (1.45%) from their paychecks. Depending on your location, you may also need to withhold state income tax, local income tax, or both. These aren't suggestions or best practices—they're legal requirements established by the IRS and state revenue agencies.

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Federal income tax withholding is calculated based on information your employee provides on their W-4 form. This form tells you how much to withhold based on their filing status, number of dependents, and other life circumstances. The IRS publishes withholding tables and calculations each year, and the amounts change based on tax law changes. For example, the IRS released new W-4 forms in 2020 that changed how employees report their withholding preferences. If you're using outdated information, your withholding calculations could be incorrect.

Social Security and Medicare taxes are straightforward: they're a fixed percentage of gross wages. However, Social Security tax only applies to earnings up to a certain threshold each year. In 2024, that threshold is $168,600. Once an employee's earnings exceed this amount, you stop withholding Social Security tax from their additional paychecks. Medicare tax, however, continues on all wages with no upper limit. Additionally, there's an additional Medicare tax of 0.9% that applies to employees earning over certain thresholds ($200,000 for single filers, $250,000 for married filing jointly).

State and local tax withholding varies significantly by location. Some states have no income tax, while others have rates ranging from 1% to over 13%. Some cities impose local taxes on residents and employees who work within city limits. A guide on payroll processing typically includes information about how to research your specific state and local tax requirements, where to find withholding tables, and how to adjust your payroll system to account for these obligations.

Practical Takeaway: Create a document listing all federal, state, and local taxes that apply to your specific business location and update it annually. Keep copies of current W-4 forms and tax tables from the IRS and your state revenue agency. When tax laws change (which happens frequently), review your withholding calculations to ensure accuracy.

Payroll Deductions Beyond Taxes

While taxes are the largest deductions from employee paychecks, they're not the only ones. Understanding what deductions are optional versus required helps you set up payroll correctly and keep employees informed about what's coming out of their pay.

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Required deductions include taxes as discussed above, but also court-ordered garnishments. If an employee has a court judgment against them (for child support, unpaid debts, or student loans), you may receive a court order requiring you to withhold a specific amount from their paychecks. You are legally obligated to follow these orders. If you receive a garnishment order, it specifies exactly how much to withhold, where to send the money, and how long to maintain the withholding.

Voluntary deductions are those employees choose to make. These include health insurance premiums, retirement plan contributions (like 401k contributions), flexible spending account contributions, life insurance premiums, union dues, and charitable donations. Some of these are pre-tax deductions, meaning they reduce the employee's taxable income, while others are post-tax deductions taken after taxes have been calculated. Understanding the difference matters because it affects both what the employee owes in taxes and what the employer owes in payroll taxes.

For example, if an employee contributes $200 per month to a pre-tax 401k plan, that $200 comes out before you calculate federal income tax, Social Security, and Medicare taxes. This reduces the employee's taxable income for the month. However, it doesn't reduce what the employee owes in Social Security or Medicare taxes—only income tax. In contrast, post-tax deductions like certain insurance plans or charitable donations come out after all taxes have been calculated, so they don't reduce the employee's tax burden.

A payroll processing guide typically explains how different deductions interact with tax calculations and provides examples of common deductions and how to set them up in your payroll system. This helps prevent errors where deductions are taken at the wrong time in the calculation process, which can result in incorrect tax withholding.

Practical Takeaway: Maintain a clear record of each employee's voluntary deductions and confirm annually that these deductions are still current. When an employee adds or removes a deduction, update your payroll system immediately to avoid processing errors.

Record-Keeping and Documentation Requirements

The IRS and state agencies require you to keep detailed records of your payroll activity. These records serve multiple purposes: they document your tax compliance, they protect you if questions arise about what you paid to employees, and they're necessary if the IRS audits your business. Record-keeping isn't glamorous, but it's critical to managing payroll responsibly.

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At minimum, you must keep records showing each employee's name, address, Social Security number, and position. You need to document hours worked (or salary amount for salaried employees), gross pay calculations, all deductions and withholdings, net pay, and the date of payment. You should retain copies of W-4 forms and any other tax-related forms employees complete. If an employee is paid hourly, you need timesheets or a time-tracking system that shows when they worked.

The IRS generally requires you to keep payroll records for at least four years. Some states require longer retention periods. In practice, keeping records for at least seven years provides extra protection. You can store these records electronically or on paper, but they must be organized in a way that allows you to retrieve information quickly if needed. If you're audited, you'll need to produce payroll records showing you withheld the correct amounts and filed the required reports.

Documentation of tax deposits is also essential. When you pay withheld taxes to the IRS and state agencies, keep records showing the date, amount, and receipt or confirmation number. The IRS provides deposit receipts, and state agencies typically provide confirmation of payment. These documents prove you've paid what you owe. Without them, if there's a discrepancy between what you reported and what the agency received, you'll have no proof of payment.

Additionally, you should document any changes to employee tax information. If an employee