Payroll basics: How payroll works
Good afternoon my name is Janice Hurley and I will be your presenter today.
Welcome to the Canada Revenue Agency's webinar, Payroll basics // How payroll works.
This presentation provides an overview of Canadian payroll basics. It’s for people who are getting ready to hire and pay employees or who are new to payroll. In this presentation, we will talk about some of the basic things that an employer needs to know about paying employees for work performed. It’s important that employers understand their roles and responsibilities to both the Canada Revenue Agency and their employees.
Employees who want a better understanding of their paycheque may also find it useful.
This is the second presentation in a series of 4 on payroll basics. The others will build on the concepts and information in this presentation, and also delve into more complex payroll issues. The first presentation explained how to determine if someone was an employee or self-employed and will be available on the CRA website soon.
Here are some of the topics we will discuss today.
We will focus on the first four steps of the payroll cycle, how to calculate gross and net pay, and how to calculate the amounts to withhold from an employee’s pay. We will also discuss the employer’s portion of Canada Pension Plan contributions and Employment Insurance premiums.
The first responsibility of the employer, after the employee starts working, is to calculate the gross pay. It could be based on a rate per hour or it could be based on an annual salary.
This is between the employee and employer and does not concern CRA directly. The CRA only needs to know when the employer pays the employee, but not when the employee does the work.
Let’s look at 2 hypothetical employees, John and Mary, who both work 40 hours every week and receive their paycheques every Friday.
- John is 25 years old, a single parent who also attends university part-time. He earns a salary of $26,000 per year.
- Mary is a 16 year old who doesn’t go to school. She earns $12.50 per hour.
At the end of each week, they have earned a gross pay of $500. On the screen, you can see the employer’s calculation.
For the sake of this example, we are keeping their pay very simple and straightforward. If you have any questions about how much you have to pay your employees or whether you have to pay vacation pay or overtime pay, you should check with the labour standards in your jurisdiction. However, in the later presentations in this series, we will talk about how to calculate those types of payments and how to withhold from them.
At the end of the pay period, after calculating the employee’s gross pay, the employer must calculate the amounts they have to withhold from the employee`s pay. There are three main types of amounts the employer must withhold, or deduct, from the employee:
- Canada Pension Plan contributions, or CPP
- Employment Insurance premiums, or EI and
- Federal and provincial or territorial income tax
Together, these are sometimes called ‘source deductions’ or ‘payroll deductions’. Let’s look at what these mean and how to calculate the amounts to withhold.
First let’s look at the Canada Pension Plan, or CPP. For employees in Quebec, instead of the CPP, their employers must withhold Quebec Pension Plan or QPP contributions. The rates for the QPP are different from CPP, but the principles are the same. If you have any questions about the QPP, you can get more information from Revenu Quebec, who administers the QPP.
Employees contribute to the CPP when they work, so that when they draw benefits from the CPP when they retire. The employer has to deduct CPP contributions from an employee’s pensionable earnings if the employee:
- First, is in pensionable employment during the year. The CPP is a mandatory pension plan and employees generally hold pensionable employment in Canada, so most employment income is pensionable.
- Secondly, is not considered to be disabled under the CPP or the Quebec Pension Plan (QPP) and
- Third, is between 18-70 years old, even if they receive a CPP or QPP pension. Employees who are younger than 18, or older than 70, do not contribute to the CPP.
There is an exception if the employee is 65 to 70 years old and gives the employer a completed form CPT 30, /Election to Stop Contributing to the Canada Pension Plan, or Revocation of a Prior Election/. This form allows the employee to choose to stop contributing to the CPP, or to choose to re-start contributing.
You can find more information about the CPP on the CRA website. But let’s look at how the CPP works.
You can find all of this information on the CRA website.
Employees must contribute 4.95% of their pensionable earnings to the CPP up to a maximum. In other words the employer stops deducting CPP contributions once the employee’s annual earnings reach $53,600 in 2015.
There is also a basic annual exemption of $3,500, which means the maximum amount of earnings for which an employee contributes to the CPP is $53,600 minus $3,500, or $50,100. These are called contributory earnings.
When we multiply the maximum contributory earnings by the contribution rate, we get $50,100 times 4.95%, which equals $2,479.95.
That means that the employer must not withhold any more than $2,479.95 from an employee in 2015.
Let’s look at how this works for John.
His income for the pay period is $500, and it is all pensionable income.
He is entitled to the basic annual exemption of $3,500. Since John gets paid every week, we divide the annual exemption by the number of pay periods (52) to get a weekly exemption of $67.31.
We subtract the basic exemption from the pensionable earnings to find John’s contributory earnings, and we arrive at $432.69.
Then we multiply the contributory earnings by the CPP rate of 4.95% and we get John’s CPP contribution of $21.42.
Sometimes, people ask if they can just not withhold CPP from the first $3,500 and then start withholding 4.95% after that. The answer is no. The basic exemption is prorated throughout the year, so you have to use the math approach we just discussed. But don’t worry … you don’t have to do the arithmetic yourself. Later, I will show you some tools that the CRA offers to help you calculate these deductions.
But what about Mary?
Remember that Mary is only 16 years old. Even though she earns the same income as John, she doesn’t contribute to the CPP so her employer doesn’t have to withhold any CPP from her pay.
As soon as Mary turns 18, her employer will have to start withholding CPP contributions. We won’t discuss how to handle this situation today, but if you are interested there is more information on the CRA website about this. Also, the Payroll Deductions Online Calculator (which we will look at shortly) will help you.
Next, let’s look at Employment Insurance, or EI premiums.
In some ways, EI is similar to CPP. Most employment income in Canada is EI insurable, and employees contribute to the plan so that they can draw benefits from the plan if they have a period of unemployment, maybe due to being laid off, becoming a parent, or other types of periods of leave from work. You have to withhold EI premiums from your employee’s pay and, unlike the CPP, there is no minimum or maximum age and there is no basic exemption.
The EI rate is 1.88% of insurable earnings up to a maximum of $49,500 in earnings or $930.60 in EI premiums. Once an employee reaches the maximum, the employer must stop withholding EI premiums.
The Province of Quebec administers a separate insurance program, so Quebec employees contribute to EI premiums at a lower rate and they also contribute to the Quebec Parental Insurance Plan or QPIP. For information about Quebec’s programs, you can contact Revenu Quebec.
So, for both John and Mary, the EI premiums will be the same. We will take their annual insurable earnings; multiply it by the EI rate of 1.88%, which gives us $488.80 in EI premiums for the year or $9.40 per pay. Once again, it’s not necessary for you to do this arithmetic because the CRA tools will do that for you, but it’s helpful to understand how the calculation works.
Finally, let’s look at income tax.
A person’s income tax is based on the amount of income they earn in the year, the amount of tax credits they are entitled to claim, and both the federal tax rate and the provincial or territorial tax rate. The actual calculation can be complex depending on each person’s tax situation, so we won’t go through all the arithmetic like we did for CPP and EI.
Let’s just look at the last 2 factors, the income and the tax credits, for our two employees, John and Mary.
We said that John earns an annual salary of $26,000 per year.
We said that Mary earns $12.50 per hour. If Mary works 40 hours a week all year long, she will also earn $26,000.
You can see that both John and Mary earn the same annual income, even though John is a salaried employee and Mary is paid by the hour. For tax purposes, the difference isn’t important.
But the difference between their tax credits is important.
Remember that John is a 25-year old single parent and a post-secondary student. That means that he can claim tax credits for his post-secondary costs. He can also claim an amount for an eligible dependent - for his child.
Mary, on the other hand, is only eligible to claim the basic personal amount.
But how does the employer know what credits John and Mary can claim? And what does the employer do with the information?
The employer needs to know approximately how much the employee is eligible to claim in tax credits in order to calculate how much income tax to withhold.
Here is a portion of form TD1, the personal tax credits return. As soon as an employer hires an employee, they should ask the employee to complete this form. It lists certain tax credits that the employee may be entitled to claim. It also prompts the employee to fill out their full name, address and social insurance number, which the employer will need for their records and for filing the T4 slips at the end of the year.
When the employee completes form TD1, they will have an estimate of the total tax credits they are entitled to receive. If their tax situation changes, the employee should complete a new TD1 form and give it to the employer within 7 days of the change. The employer should keep a copy with their records because it supports the calculation for withholding and remitting the payroll deductions. On the other side of the form, there is a box where an employee can indicate if they want the employer to withhold additional tax. If your employee does this, you have to accept their request and withhold the additional tax indicated.
The total personal amount an employee claims on a TD1 form will determine which claim code to use. Claim codes help employers determine how much income tax to deduct. We will talk about more about claim codes later.
You can see that the basic personal amount is already populated. Both John and Mary are eligible to claim this amount.
But John is also eligible to claim an amount for his tuition, education and textbooks. Line 5 of the TD1 form tells John how to calculate this amount for the TD1 form. This is an estimate of the actual amount he will be eligible to claim on his tax return, so it helps the employer know how much income tax to withhold.
In John’s case, let’s assume that the amount he can claim is $5,000.
John can also claim the amount for an eligible dependent since he doesn’t have a spouse and he does support a dependent.
Assuming that his child doesn’t earn any income, John can claim the full amount of $11,327. If the child did earn some income, John would subtract the dependent’s income from $11,327 and claim the difference.
So you can see that the total of John’s tax credits is $27,654, while Mary’s is $11,327 for the basic personal amount only.
Next, the employer will need to determine which claim code to use for each employee based on their tax credits. You can find an explanation of the claim codes on page A-8 of guide T4032, Payroll Deductions Tables, or on the CRA website.
Here is an excerpt from the guide.
You can see that Mary, whose credits total $11,327, has claim code 1, while John, whose credits total $27,654, has claim code 9.
It is important to note that there are 2 TD1 forms, 1 for federal tax and 1 for provincial or territorial tax. The employee should complete the federal form and the form for the province or territory where they live. The claim codes for federal tax and provincial or territorial tax may not be the same.
You can also see that there is a claim code 0 for employees who do not have any amounts to claim. This would apply for an employee who has 2 different employers, because only 1 employer should account for the tax credits or the employee will end up owing tax when they file their return.
So, we have talked about the three main source deductions, and we have estimated the CPP and EI amounts that the employer has to withhold from John and Mary. But we haven’t calculated the tax to withhold.
Since the tax calculation can be complex, let’s use the payroll deductions online calculator to figure out how much John’s and Mary’s employer has to withhold. The calculator will also confirm that we calculated the right amounts for CPP and EI. As I mentioned, you don’t have to do the math every time. The calculator will do it for you. If you prefer not to use the calculator, you can use the Payroll Deductions Tables in Guide T4032 that we used for the claim code.
Let’s walk through the Payroll Deductions Online Calculator, or PDOC. You can find it at www.cra.gc.ca/PDOC
There will be a disclaimer page, so you can read the information and click “I accept” to continue.
Then you will see a page where you have to select the type of calculation. We will leave the default selection for salary and click next.
This is the first step of the salary calculation. You have to enter the province or territory of employment so that the calculator will know which tax rates to use. You have to select the pay period frequency so the calculator will know how many pay periods your employee will have throughout the year. And you have to indicate the date when the employee is paid so the calculator will use the correct rates, especially since tax rates and the EI rate can change annually, and sometimes the tax rates changes during the year.
You also have the option to enter the employee’s name and the employer’s name. This can be useful but it’s not necessary.
We will use the same province, pay period frequency and date for John and Mary.
Then click next.
This is the second step of the salary calculation.
For both John and Mary, we will enter the gross income of $500 for the week. We also select ‘no bonus or retroactive payment’.
Then click next.
This is the third step of the salary calculation, and this is where John’s and Mary’s calculations will differ from each other.
In the top box, you will indicate the employee’s claim amount or claim code from the federal TD1 form. For John, it was $27,654 or claim code 9. We haven’t looked at the provincial TD1 form, but the process is the same. Using John’s hypothetical information, he would have a provincial credit amount of $23,390 or claim code 8. Notice that the federal and provincial claim codes are not the same. This is the reason the employee has to complete both forms.
For Mary, on the other hand, the federal and provincial claim codes are both 1. Since she is only 16, she is CPP exempt, so select CPP exempt. This will allow the PDOC to calculate her payroll deductions accurately.
You can also indicate that the employee has reached the maximum annual contribution amount for the year, or you can indicate the year-to-date amount of pensionable earnings from your records. This may be useful if your employee is close to the maximum. Although the PDOC will use the amount you enter to calculate this pay, it will not save the information for future calculations.
Lower on the page, there are boxes to indicate whether the employee has reached the maximum EI premium, or whether they are EI exempt, or to type in the premiums deducted year-to-date. Since there is no minimum age for EI, neither John nor Mary is EI exempt. Similar to CPP, you can show how much EI you have withheld so far during the year so the PDOC will stop you from deducting too much. But the calculator will not save this information for subsequent calculations. Each calculation is only as good as the information you enter.
At the bottom of the page, right before you click calculate, there is a box to indicate the employer’s EI premium rate. We haven’t talked about that yet, so for now, we will leave the default rate of 1.4 times the employee’s premium. That is the usual rate, but we will talk about this when we discuss the employer’s contributions to payroll deductions.
So let’s click calculate.
Finally, the PDOC will give you the results. You can see the differences between John’s and Mary’s payroll deductions and net pay.
John, due to his higher personal tax credits, has less tax withheld than Mary. However, since he is CPP pensionable, he is subject to withholding for CPP contributions while Mary is exempt.
The top of the results page shows the information you entered, including the optional information.
The bottom of the results page shows the year-to-date information, based again on the information you input. Remember that the PDOC does not save this information.
You should keep a copy of the results page for your records.
Now that the employer has calculated the amounts they must withhold from the employee’s pay, they can pay the employee the gross amount minus the amounts they withhold, which is the net pay.
Give the employee a pay slip that shows the deductions, and keep a copy for your records.
You can see that, even though they earned the same gross pay, John and Mary each receive a different net pay because of their different tax situations.
Here is a summary of what we have done so far.
John and Mary each earned $500 but, because John is entitled to a higher amount of personal tax credits and because Mary is exempt from contributing to CPP, their net pay is different.
Now let’s move on to the next part of the payroll process.
The employer sets aside the amounts withheld from the employees. The employer must also contribute their portion of CPP contributions and EI premiums. Together, these will form the remittance amount that the employer must send to the CRA.
For CPP, the employer must match the employee’s contributions. Since John had $21.42 withheld from his pay for CPP, John’s employer must contribute $21.42 as well. For Mary, of course, who is exempt from CPP, the employer does not have to contribute either.
Once the employee reaches the maximum CPP contribution for the year, the employer also reaches the maximum and can stop both withholding and contributing for that employee.
Similarly, the employer has to contribute EI premiums as well. Usually, the employer contributes 1.4 times the amount of the employee’s premiums. Some employers may qualify to contribute to EI at a reduced rate if they provide a wage-loss replacement plan for short-term disability to their employees. You can find more information about this on the CRA website but, if it doesn’t apply to you, you will contribute at the usual rate.
The PDOC can help you figure out your share, as well. Remember that there was a box where you could indicate your EI rate, on slide 28 for those who have downloaded a copy of the presentation. At the bottom of the results page, you have the option to print an employer remittance summary...
...which shows you the Employee CPP and EI contributions, as well as the employer portions for both. You can see here that, for John’s September 4 paycheque, the employer must remit $71.17
If we were to print a similar employer remittance summary for Mary, the employer won’t have any CPP to withhold or contribute, but the EI amounts will be the same as they are for John, $22.56, and she will also have federal and provincial taxes deducted.
Here is a summary of what we have done so far.
It is very important to note that the amounts the employer withholds from their employees are funds held in trust for the Government of Canada. It’s up to the employer to manage their business affairs. The CRA does not specifically require the employer to keep the funds in a separate bank account, but they must be held separate and apart from the business operating capital.
Now that we have looked at what amounts need to be remitted, let’s move on to the next step in the payroll process.
We have just looked at John’s and Mary’s paycheques that they received September 4, and we have looked at the employer contributions.
It’s important to understand that it does not matter when the employee worked. What matters is when the employer paid the employee because that is the date that the employer withheld the source deductions.
Employers have to remit these amounts to the CRA on a regular basis. How often an employer remits their source deductions depends on when they pay their employees and how much they withhold.
Most new employers are regular remitters. That means that they have to make their remittance to the CRA no later than the 15th of the month following the month in which they withheld the source deductions. Our employees, John and Mary, receive their paycheques every Friday. In September 2015, they receive 4 paycheques and the employer withholds the source deductions every Friday. As a regular remitter, the employer must add up all the amounts withheld during the month, plus their portion of CPP and EI, and remit that amount to the CRA by October 15, 2015.
It’s very important to realize that the CRA must receive the remittance by October 15. It’s not good enough to mail a cheque by the 15th. If the CRA receives the remittance later than the 15th, the employer may have to pay a penalty and interest on the late payment plus the penalty.
Some employers qualify to remit their payroll deductions every quarter, rather than every month. This is the case for employers whose average monthly withholding amount is less than $3,000 and who have at least 1 year of perfect compliance history.
As John and Mary’s employer, your average monthly withholding amount is below $3,000. After one full year of withholding, remitting, and filing correctly and on time, you would be eligible to become a quarterly remitter.
Starting in 2016, certain new employers will also be able to remit their payroll deductions on a quarterly basis. This would apply to new employers who have a monthly remittance of less than $1,000. This won’t affect you unless your first pay date is after December 31, 2015. As John and Mary’s employer, you remit less than $1,000 each month, so you would likely be an eligible new employer if their first pay was on January 1, 2016 or later.
However, in this case, you first paid John and Mary in September 2015, so the new remitter category would not apply.
Some employers have to remit their payroll deductions more frequently and the due date can be sooner after the end of their pay period. However, most new employers will not be affected by this, so we will not be discussing those obligations. If you want more information about accelerated remitters, you can find it on the CRA website.
At the end of each calendar year, the employer prepares the T4 slips and distributes them to the employees and the CRA. We will talk about how to do that in a later presentation of this series. For now, it’s enough to know that the T4 slips show how much gross income the employee earned, how much the employer withheld for income tax, CPP contributions and EI premiums, and the employee’s pensionable earnings and insurable earnings. The T4 also shows other types of deductions that we haven’t talked about today.
What’s important to remember here is that the goal for the employer is to balance to zero, meaning that the total amounts withheld from employees plus the total amounts of employer portions of CPP and EI should equal the total amount the employer remitted to the CRA throughout the year.
Finally, the employee uses their T4 slips to file their personal income tax and benefits return. Again, the goal is to be as close as possible to zero, which means that the total amounts withheld from the employee’s pay throughout the year equals the total amounts the employee has to pay in income tax, CPP contributions and EI premiums on the income. That way, the employee doesn’t owe the CRA any money, and the CRA doesn’t owe the employee a refund.
Here are some payroll resources that you can find on the CRA website, including a calculator to help calculate payroll deductions and a tool your employee can use to estimate their personal tax credits. You can also find information about other topics related to payroll.
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