Payroll deductions are wages withheld from an employee’s total earnings. The withholdings are reserved for paying taxes, benefits, and garnishments.
Payroll deductions are reflected on an employee’s paycheck and include both mandatory and voluntary payroll deductions. Some payroll deductions are pre-tax, while others are withheld post-tax.
What are payroll deductions?
Payroll deductions are earnings withheld from an employee’s paycheck to pay for various taxes, benefits, and garnishments, without affecting the employee’s cost to the company. The total withholdings account for the difference between gross pay and net pay, impacting the amount of money an employee takes home.
How do payroll deductions work?
The below case looks at the process in the USA, make sure to check the tax regulations that are local to each employee.
The employer is responsible for withholding wages from an employee’s paycheck, particularly mandatory deductions.
Effective payroll software tools automate the calculation, reducing error and ensuring compliance. Payroll solutions are especially useful when calculating payroll deductions for a global team.
It is the employee’s responsibility to provide written authorization for voluntary payroll deductions. These details are outlined on the individual employee’s Form W-4 Employee Withholding Certificate.
Depending on the specific deduction and jurisdiction of both employee and employer, payroll deductions work in the following ways.
As the name implies, pretax deductions are withheld from an employee’s paycheck before any federal taxes are withheld. In the process, pretax deductions reduce the amount of taxable income earned and lower the employee’s Federal Unemployment Tax (FUTA).
Examples of pretax deductions include:
- Health insurance
- Group-term life insurance
- Retirement plans
Employees don’t need to participate in these contributions. However, it’s beneficial that employees contribute as it saves money compared to paying for the above benefits on a post-tax basis.
Take note that the Internal Revenue Service (IRS) specifies a contribution limit, such as the total amount that can be paid to a 401(k) retirement plan on a pre-tax basis each year.
Statutory deductions are mandatory payments allocated to government agencies for public programs and services.
Statutory deductions include the following payments:
- Federal income tax withholding — applied to salaries, cash gifts, tips, bonuses, and unemployment benefits, ranging from 10% marginal rate to 37%
- Medicare — calculated as 1.45% of income
- Social Security — calculated as 6.2% of income
- Federal Insurance Contributions Act (FICA) tax — support Medicare and Social Security
- State income tax — only applicable to certain states
The work status of the employee impacts their filing status and how these deductions are paid. For example, independent contractors are considered self-employed, and hiring their services dissolves the employee of responsibility for managing income tax withholding.
FICA taxes contribute to an employee’s Social Security and Medicare payments. Employees typically pay 1.45% of their income toward Medicare and 6.2% of their earnings toward Social Security, totaling 7.65% in FICA taxes. An employee is legally obligated to match this contribution.
Additional Medicare tax of 0.9% applies to certain employees, self-employment income, and railroad retirement (RRTA) compensation. In this instance, employers deduct 0.9% from the employee’s wages starting with the pay period where the individual’s earnings exceed $200,000. It’s not required that these contributions are matched.
State and local taxes
The amount owed on state and local taxes is determined by the state where the employee receives the income. While some states charge a fixed rate, others use tax brackets, and some have no charge at all.
As of 2020, the following American states do not have income tax payroll deductions:
- South Dakota
When hiring a remote team, it’s important to consider compliance and local tax regulations.
Once all of the required taxes have been withheld, post-tax deductions are withheld. As the deductions reduce the employee’s net pay rather than the gross pay, post-tax deductions don’t impact the individual’s tax burden.
Common post-tax deductions include:
- Roth IRA retirement plans
- Disability insurance
- Union donations
- Donations to charity
- Wage garnishments
Each of these post-deductions is voluntary, except for wage garnishments which employees may be ordered to pay.
Wage garnishments are legally required to be withheld by an employer under the instruction of a court order. A garnishment order serves to withhold a portion of an employee’s net wages to cover various expenses such as:
- Child support payments
- Unpaid taxes (federal or state)
- Defaulted student loans
- Other monetary fines
Different types of income that are applicable to be garnished include hourly wages, salaries, commissions, bonuses, and retirement plan payments.
If wage garnishments are paid incorrectly, then the business is responsible for the back payments and not the employee. During these calculations, the Title III of the Consumer Credit Protection Act (CCPA) must be considered regarding the amount garnished from wages.
Employees can pull more of their wages to cover the cost of various employee benefits. Voluntary payroll deductions are not required by law but are often beneficial for employees and the employer. Voluntary deductions can be withheld on a pretax basis or a post-tax basis.
Getting an employee’s written consent is important before withholding any voluntary deductions from their pay.
Offering health care insurance coverage is an attractive benefit when hiring from a competitive talent pool. Health benefits, such as medical, dental, and vision coverage, also contribute to a high retention rate. Making contributions through a Section 125 plan on a pre-tax basis offers a financial advantage.
Group-term life insurance
Another way to attract new talent involves offering basic term life insurance of up to $50,000 of coverage. If employees wish to supplement this contribution, the funds are deducted on an after-tax basis.
Two of the most popular retirement options include a 401(k) and Roth Individual Retirement Account (IRA). Employee contributions to a 401(k) are subject to FICA taxes, while IRA contributions are withheld on a post-tax basis.
Job-related expenses are mostly applicable in unionized jobs where employers are liable to pay for employee membership and any taxable benefits associated with the union dues. Other job expenses include uniforms, meals, and travel expenses. Again, assessing local legislature is important as some states may forbid these deductions.
How to calculate payroll deduction
Payroll deductions are determined during the payroll processing period. Mandatory and voluntary payroll deductions are considered when calculating an employee’s pay. The following steps are taken when calculating payroll deductions:
- Acquire a W-4 form from each employee to confirm which deductions to withhold
- Calculate employee’s gross pay (using salary or multiplying hourly wages)
- Determine the amount of overtime owed to the employee
- Adjust gross pay for Social Security wages
- Calculate Federal Income Tax
- Calculate FICA taxes
- Subtract state income tax deductions
- Deduction other optional deductions
Each of these items should reflect on the employee’s pay stub, leading to the final take-home pay. As an employer, business owners are also responsible for employer payroll taxes.
A payroll calculator streamlines the process of calculating payroll deductions. The payroll service also ensures that processes are compliant and up to date.
Payroll calculations can be overwhelming at times, yet it’s important to remain compliant. Consider the following questions as a summary of popular payroll questions.
What are the 4 mandatory payroll deductions?
While some payroll deductions are voluntary, the following types of deductions are mandatory and should be considered by all companies:
- Federal income tax
- State and local taxes
- FICA taxes
- Wage garnishments
What are the types of payroll deductions?
Payroll deductions can be categorized in various ways. Most commonly, they are identified as voluntary and mandatory deductions, as well as pre-tax and post-tax deductions.
- Voluntary deductions — an employee may choose to subtract voluntary deductions from their gross pay
- Mandatory deductions — employers are legally required to withhold mandatory deductions from an employee’s paycheck
- Pre-tax deductions — deductions are subtracted from an employee’s paycheck before tax are withheld
- Post-tax deductions — deductions are subtracted from an employee’s earnings after taxes are withheld
What does the term "payroll deduction" refer to?
Payroll deductions are wages withheld from an employee’s total earnings to contribute toward paying taxes, garnishments and benefits. The amount is deducted from the payroll before wages are paid, and the amount attributed to payroll deductions is the difference between gross pay and net pay.
What is the difference between payroll deductions and withholding?
Although similar, payroll deductions and withholdings are two different terms.
Withholdings refers to the amount of money that is taken out of an employee’s paycheck to pay their income taxes due for the pay period.
Deductions refer to the amount of money taken out of an employee’s paycheck to pay for selected benefits and donations chosen by the employee. For example, retirement, healthcare, or special funds. Employees may pay for the full benefit or contribute to a portion of the total.
In most instances, tax withholdings are determined by law and employers withhold the stipulated amount from the employee. Deductions are usually voluntary and determined by the employee’s preferences. It’s important to calculate the correct amount as falling short demands the difference be paid when filing a tax return.