How to Run Payroll: From Setup to Tax Filings

Payroll is essential for any business with employees, involving calculating wages, withholding taxes, and paying employees. It impacts employee satisfaction and ensures compliance with regulations. Accurate and timely payroll management maintains good standing with tax authorities and fosters a positive work environment.

Setting Up Your Payroll Foundation

Establishing a payroll system requires preliminary steps. This involves securing identification numbers and gathering employee information. This groundwork ensures compliance and smooth operations.

Obtain an Employer Identification Number (EIN) from the IRS. This number is essential for federal tax filings and required when hiring employees. Register with state and local tax authorities for obligations like state unemployment insurance and income tax withholding. Registrations vary by jurisdiction but ensure proper tax management.

Collecting accurate employee information is an important task. New hires must complete Form W-4, Employee’s Withholding Certificate, to determine federal income tax withholding. This form helps employees align withholding with tax liability. Employees also complete Form I-9, Employment Eligibility Verification, to verify identity and legal work authorization. Employers must examine and retain presented documents.

Collect personal details like full name, address, and Social Security Number. For direct deposit, gather banking information including bank name, routing, and account numbers. Establish clear pay periods (weekly, bi-weekly, semi-monthly, or monthly) to dictate payroll frequency. Classify workers as employees or independent contractors, as this impacts tax obligations and legal responsibilities.

Calculating Employee Pay and Deductions

After setup, calculate each employee’s pay and deductions for every pay period. This involves determining gross wages, applying mandatory withholdings, and accounting for voluntary deductions. The goal is to arrive at the correct net pay.

Gross wages are all earnings before deductions. This includes hourly wages, fixed salaries, commissions, bonuses, and overtime pay. Overtime, paid at one and a half times the regular rate for hours over 40 in a workweek, must be tracked. Accurate gross wage calculation ensures the correct base for deductions.

Mandatory deductions are applied after gross wages are determined. Federal Income Tax (FIT) withholding is calculated using Form W-4 and IRS tax tables, contributing to the employee’s annual federal income tax liability.

Social Security and Medicare taxes (FICA taxes) are also mandatory. For 2025, Social Security tax is 6.2% for both employee and employer, up to $176,100. Medicare tax is 1.45% for both, with no wage limit. An additional 0.9% Medicare tax applies to employee wages over $200,000.

State Income Tax (SIT) withholding is a mandatory deduction, calculated by state-specific rules and forms, varying by jurisdiction. Local income taxes may also be withheld based on local regulations. These deductions reduce an employee’s gross pay.

Employees can opt for voluntary deductions that reduce net pay. These include health insurance premiums, retirement plans (e.g., 401(k)s, IRAs), and flexible spending accounts. Some deductions, like certain retirement or health savings contributions, may be pre-tax, reducing taxable income, while others are post-tax. After all deductions, the remaining amount is the employee’s net pay.

Managing Payroll Tax Obligations

Employers have payroll tax obligations beyond employee withholdings, contributing to federal and state programs. These employer taxes are a significant employment cost and must be accurately calculated and remitted. Effective management ensures financial compliance.

Employers must match the employee’s portion of FICA taxes. This means employers contribute 6.2% for Social Security (up to $176,100) and 1.45% for Medicare (no wage limit). These contributions are in addition to employee withholdings. Total FICA tax, combining both shares, is 15.3% on wages up to the Social Security wage base, and 2.9% on wages above that, with an additional 0.9% from employees on wages over $200,000.

The Federal Unemployment Tax Act (FUTA) imposes an employer-only tax for federal unemployment insurance. For 2025, the FUTA tax rate is 6.0% on the first $7,000 of wages per employee. Employers can receive a credit of up to 5.4% for timely state unemployment contributions, reducing the net FUTA rate to 0.6%. This means the maximum FUTA tax per employee is $42 annually.

State Unemployment Tax Act (SUTA) taxes are employer-only contributions, funding state unemployment benefits. SUTA rates and wage bases vary by state, often depending on an employer’s experience rating (history of unemployment claims). Employers must understand their state’s SUTA requirements for correct calculation.

Employers must deposit federal payroll taxes, including withheld income tax and FICA taxes, according to specific schedules. Most follow monthly or semi-weekly deposit schedules, determined by total tax liability during a “lookback period.” Monthly depositors (tax liabilities of $50,000 or less in the lookback period) must deposit taxes by the 15th of the following month.

Semi-weekly depositors (liabilities exceeding $50,000) have more frequent requirements: payments Wednesday-Friday due following Wednesday; payments Saturday-Tuesday due following Friday. Deposits are primarily made through the Electronic Federal Tax Payment System (EFTPS). State-specific deposit requirements exist, often involving online portals or electronic transfers.

Processing Payments and Filings

After payroll calculations and tax obligations are determined, the next phase involves paying employees and submitting tax filings. This ensures employees receive wages and tax authorities receive payments and information.

Pay employees via direct deposit or physical checks. Direct deposit is efficient, requiring bank routing and account numbers for electronic transfers. This involves initiating an Automated Clearing House (ACH) transaction through a payroll service or bank. For physical checks, print and distribute them securely.

Employers must provide pay stubs to employees, physically or electronically. Stubs must detail gross wages, all deductions (mandatory and voluntary), net pay, and year-to-date totals for wages and taxes. Clear pay stubs ensure transparency and help employees understand earnings and deductions.

Make payroll tax deposits. Federal tax deposits (withheld income tax and FICA taxes) are primarily made through the Electronic Federal Tax Payment System (EFTPS). Employers must adhere to their assigned deposit schedule (monthly or semi-weekly) to avoid penalties. Monthly depositors remit taxes by the 15th of the month following payment. State and local tax deposits are made through online portals or designated methods, with deadlines varying by jurisdiction.

Regular filing of payroll tax forms is required. Form 941 is filed quarterly to report federal income tax, Social Security, and Medicare taxes withheld, plus the employer’s FICA share. This form summarizes tax liabilities and payments for the quarter, due by the last day of the month following each quarter (e.g., April 30 for Q1). Form 940 is filed annually to report federal unemployment taxes, due by January 31 of the following year.

Annual wage statements (Form W-2) must be prepared and distributed to employees by January 31 of the following year. This form reports annual wages and federal, state, and local taxes withheld. Employers must also file Form W-3 with the Social Security Administration (SSA) by January 31, summarizing total wages and taxes reported on all W-2 forms. State and local payroll tax forms have specific filing deadlines and methods, often involving online submissions.

Maintaining Payroll Records

Accurate record-keeping is integral to payroll management, extending beyond processing and filing. Documentation serves as a history of payroll activities, ensuring compliance and providing data for financial analysis or audits. Proper record maintenance protects the business and supports transparency.

Maintain detailed records of payroll documents. This includes timecards or other timekeeping records for hours worked. Payroll registers, summarizing each pay period’s wages, deductions, and net pay for all employees, are essential. Retain copies of all filed tax forms (e.g., Forms 941, 940, W-2s, W-3s) and confirmations of tax deposits. Employee-specific documentation, including completed Forms W-4 and I-9, direct deposit authorizations, and signed pay stubs, is also crucial.

Federal and state regulations dictate specific retention periods for payroll records. The Fair Labor Standards Act (FLSA) requires payroll records for at least three years, and wage computation records for at least two years. Tax-related records (e.g., FICA and FUTA taxes) should be kept for at least four years from the date the tax became due or was paid, whichever is later. State laws may impose longer retention periods; adhere to the longest applicable requirement.

Records can be stored in physical or digital formats. Digital storage offers accessibility, searchability, and reduced space, often with backup and security. Regardless of method, records should be organized, retrievable, and protected from loss or unauthorized access. Regular review and archiving contribute to efficient payroll administration and compliance.