Payroll 101 - Comprehensive Beginner's Guide

Processing payroll is a highly regulated and detail-oriented responsibility. It requires accounting knowledge, legal compliance, tax understanding, and coordination with HR and benefits administration. For accountants learning to process U.S. payroll for the first time, this guide provides a step-by-step walkthrough of every essential concept — from employee classification to year-end tax forms, deductions, FICA, and timesheets.

1. Understanding Employee Classification

Classifying workers properly is the first and most critical step in running payroll. It determines how taxes are withheld, how wages are reported, and whether or not an individual is eligible for benefits.

• A W-2 Employee is a traditional employee hired directly by the company. The employer withholds federal, state, and local taxes, contributes to Social Security and Medicare, and may offer health insurance, PTO, and retirement benefits. These employees receive a Form W-2 at year-end, summarizing their wages and withheld taxes.

• A 1099 Independent Contractor is a self-employed individual or service provider. The company does not withhold any taxes and does not offer benefits. The contractor is paid in full and is responsible for paying self-employment taxes. They receive a Form 1099-NEC at year-end if they earned $600 or more.

• Part-Time Employees are typically W-2 employees but work fewer than 30 hours per week. Their benefits may be limited depending on the employer's policies and state laws.

• Temporary or Agency Workers may be employed either by the company directly or through a staffing firm. If paid by the company, they must be correctly classified as W-2 or 1099 based on the degree of control and independence in their work.

Here is a definition of some of the jargon mentioned above. 

• SSN (Social Security Number): A nine-digit number issued by the Social Security Administration (SSA), used to report an employee’s wages and tax withholdings.

• Form W-4: Completed by the employee to inform the employer how much federal income tax to withhold from their paycheck. It reflects marital status, dependents, and other adjustments.

• ITIN (Individual Taxpayer Identification Number): Used by individuals not eligible for an SSN (such as some foreign nationals) to file taxes and receive compensation legally.

2. Required Payroll Setup Information

Before processing any payroll, collect the following from each employee:

• Full legal name

• Social Security Number (SSN) or ITIN

• Residential address

• Completed federal Form W-4

• Completed state withholding form (varies by state)

• Bank account information for direct deposit

• Signed employment agreement (pay rate, exempt status, benefits eligibility)

• Completed Form I-9 and required identification to verify employment eligibility

3. Calculating Gross Pay

Gross pay is the total amount an employee earns before any deductions are applied. It includes:

• Base salary or hourly wages

• Overtime pay (usually 1.5× hourly rate for time over 40 hours/week)

• Bonuses and commissions

• Shift differential and holiday pay

• Stipends (e.g., internet, wellness)

• Taxable reimbursements or allowances

4. Payroll Taxes Overview

Payroll taxes are mandatory and must be accurately withheld from employee wages and submitted to government agencies. Key payroll taxes include:

• Federal Income Tax (FIT): Based on the W-4 form and IRS tax tables.

• Social Security Tax: 6.2% of wages from the employee and employer (up to annual wage limit).

• Medicare Tax: 1.45% from both the employee and employer, with no wage cap.

• Additional Medicare Tax: 0.9% from the employee on wages over $200,000.

• Federal Unemployment Tax (FUTA): Paid only by the employer on the first $7,000 of wages.

• State Unemployment Tax (SUTA): Paid by the employer; rates and wage limits vary by state.

• State and Local Income Taxes: Based on where the employee lives and/or works.

5. Cross-State Employment

If an employee lives in one state and works in another:

• Withhold state taxes based on the work state unless there’s a reciprocity agreement allowing taxation in the home state only.

• If no agreement exists, the employee may have to file income tax returns in both states.

• Always collect both state tax forms and consult a payroll professional when unsure.

6. Voluntary Deductions

Voluntary deductions are based on employee choices and must be clearly documented. They can be pre-tax (reducing taxable income) or post-tax.

Examples include:

• Health, dental, vision insurance premiums

• 401(k) or 403(b) contributions

• Health Savings Account (HSA) or Flexible Spending Account (FSA) contributions

• Commuter benefits

• Supplemental insurance (e.g., disability, critical illness, life insurance)

• Legal plans or union dues

• Court-ordered garnishments (e.g., child support, tax debts)

7. Reimbursements vs. Stipends

• Reimbursements: Non-taxable payments for documented work-related expenses. Must be under an accountable plan and supported with receipts.

• Stipends: Fixed payments (e.g., $100/month for internet) usually considered taxable income unless tied to documented expenses.

8. Timesheet Management

Hourly and part-time employees must track time accurately:

• Record regular hours, overtime, break times, and PTO

• Supervisors must approve all timesheets

• Use digital tools (e.g., Hubstaff, TSheets, QuickBooks Time)

• Submit by payroll deadlines and cross-verify against pay calculations

9. Payroll Schedules

Typical payroll frequencies:

• Weekly – Paid every week (common for hourly roles)

• Biweekly – Paid every two weeks (26 pay periods/year)

• Semimonthly – Paid twice a month (24 pay periods/year)

• Monthly – Paid once a month (less common)

Each frequency should have a clear schedule for timesheet submission, approvals, and pay dates.

10. Year-End Reporting

As a payroll processor, you are responsible for:

• Form W-2: Sent to each employee and the Social Security Administration (SSA)

• Form W-3: Summary of all W-2s

• Form 1099-NEC: For independent contractors

• Form 941: Quarterly tax return for FIT, Social Security, and Medicare

• Form 940: Annual return for FUTA

• State reports: Include state income tax and SUTA filings

11. Common Payroll Terms

• Gross Pay: Total earnings before any deductions

• Net Pay: Take-home pay after deductions

• FICA: Refers to Social Security and Medicare taxes

• YTD (Year-to-Date): Cumulative totals for earnings or deductions

• Imputed Income: Value of non-cash benefits that are taxable

• Pre-tax vs. Post-tax: Indicates when the deduction occurs in relation to taxes

• Supplemental Wages: Includes bonuses and commissions

• Garnishment: Court-ordered deduction for legal obligations

12. What Each Deduction Means 

• Federal Income Tax (FIT) is the amount withheld from an employee’s paycheck based on federal tax brackets and their W-4 elections. This money goes to the IRS and helps fund federal services.

• Social Security Tax (FICA-SS) is 6.2% of an employee’s wages, matched by the employer, and funds retirement, survivor, and disability benefits.

• Medicare Tax (FICA-MED) is 1.45% of wages, matched by the employer. An extra 0.9% is withheld from employees earning over $200,000, which employers do not match. This funds healthcare for retirees and people with disabilities.

• State Income Tax is withheld from employee wages and paid to the employee’s state of residence or employment. Not all states have this tax.

• Local Income Tax may apply in certain cities or counties (e.g., NYC), and is withheld based on the employee’s work location.

• Federal Unemployment Tax (FUTA) is paid by the employer to fund federal unemployment programs. It applies to the first $7,000 of wages per employee annually.

• State Unemployment Tax (SUTA/SUI) is paid by the employer and varies by state. It helps fund state unemployment insurance.

• Health Insurance Premiums are typically pre-tax deductions taken from employee pay to cover medical, dental, and vision plans.

• 401(k) or 403(b) Contributions are pre-tax or Roth (post-tax) retirement savings deducted from employee pay.

• Health Savings Account (HSA) contributions allow employees in high-deductible health plans to save pre-tax money for healthcare expenses.

• Flexible Spending Account (FSA) contributions are pre-tax and used for eligible medical or dependent care expenses, subject to “use-it-or-lose-it” rules.

• Commuter Benefits allow employees to use pre-tax earnings for mass transit or parking, within IRS limits.

• Short-Term Disability Insurance provides income for temporary health-related absences. Taxability depends on who pays the premium.

• Long-Term Disability Insurance covers extended absences and is generally non-taxable if the employee pays with post-tax dollars.

• Life Insurance over $50,000 is taxable as imputed income. The first $50,000 of employer-paid coverage is generally tax-free.

• Critical Illness and Hospital Indemnity Insurance provide fixed payments for certain illnesses or hospitalization and are post-tax deductions.

• Legal Plans are post-tax deductions for access to legal services such as consultations or document preparation.

• Union Dues or Professional Fees are deducted post-tax as required by union or membership agreements.

• Garnishments are court-ordered deductions such as child support or tax debt. They must be processed in order of legal priority.

Conclusion

U.S. payroll processing is a complex but essential part of business operations. As an accountant, you are responsible for accurate payments, timely tax filings, and full compliance with federal and state laws. This guide gives you the foundational knowledge to confidently navigate payroll from setup to year-end.

Use trusted payroll software, consult legal and HR professionals when needed, and always keep up with changing laws and tax rates. When in doubt — document everything, double-check calculations, and prioritize compliance. At PLUS Accounting Services we are always here to help.