What are payroll deductions?
To put it simply, payroll deductions are wages withheld from an employee’s paycheck for taxes, benefits or garnishments. Deductions are either mandatory or voluntary and are taken out in a specific order since some are pre-tax, and the rest are post-tax.
No matter if an employee is part time or full time, payroll deductions must be withheld from every payroll check. If no deductions are withheld, the employer is liable for all the mandated amounts that were supposed to be withheld. It is always the responsibility of the employer to make sure all payroll deductions are withheld in a timely manner.
While the employer is responsible to pay the mandated deductions, the amount that is actually withheld from each check will vary based on the withholding allowances the employee selects, state or local taxes, and the benefits offered by the company.
The basics of payroll deductions
Payroll deductions are generally processed each pay period and are based on the applicable tax laws and withholding information supplied by employees or a court order. Employers can either calculate them manually or automate the process using a payroll software. The benefits of using a payroll software and why many businesses choose to automate their payroll is because it reduces errors and ensures that payments are filed with the proper authorities on time.
Every time payroll is run, the employer is responsible for taking out the correct deductions for each employee and making sure the amount withheld is correct depending on their individual Form W-4 Employee’s Withholding Certificate, state and local withholding certificates, benefit selections and other details. Payroll deductions are specific to employees, which means, employers are not responsible for payroll deductions for independent contractors.
When an employee receives their paycheck, they’re getting their net pay, as opposed to their gross pay. What’s the difference? Gross pay is the total amount before payroll deductions, and net pay is the pay the employee takes home after deductions. When they receive their paycheck, employees will see a break-out of their payroll deductions.
There are two types of payroll deductions: mandatory and voluntary. Let’s get into the details of each type.
Types of mandatory payroll deductions
In a nutshell, mandatory payroll deductions are required by law, like federal and state income taxes.
These deductions are related to the employer’s payroll tax liability, so it’s important to consistently withhold the correct amount every pay period. Failure to withhold these deductions and comply with the law can result in fines and penalties. There are five main types of mandatory deductions:
- Federal Income Tax
- Social Security and Medicare
- State and Local Income Tax
- State Unemployment Insurance
- Court-Ordered Garnishments and Payment to Creditors
Federal income tax
All employers are responsible for deducting federal income taxes from each employees’ paycheck every pay period. Federal income taxes are regulated by the government and are used for national programs like defense, education, etc.
The amount withheld from an employee’s paycheck depends on their gross pay, along with the allowances they claim on their W-4. The amount of federal income tax ranges from 10 percent to 37 percent of an employee’s taxable income.
FICA tax (Social Security and Medicare)
Like federal income taxes, FICA taxes are regulated by the federal government. FICA (Federal Insurances Contributions Act) includes Social Security and Medicare taxes and, if applicable, Medicare surtax. Unlike federal income tax, FICA payroll deductions are calculated using a flat rate that’s designated by the government.
For Social Security taxes, employers must withhold 6.2 percent of an employee’s annual wages, up to $147,000 in 2022. For Medicare, employers must withhold 1.45 percent of an employee’s annual wages. The Medicare surcharge tax only applies to employees making $200,000 ($250,000 for employees who are married and filing jointly). Employers must withhold 0.9 percent of the wages that exceed this amount.
To sum it up, excluding the Medicare surcharge, employers are responsible for withholding a minimum of 7.65 percent of employees’ pay each pay period to comply with the FICA tax mandatory payroll deduction.
State and local taxes
Individual states and municipalities might require employees to pay income or other specific taxes, which means that their employer must withhold the appropriate payroll deductions. These requirements are based on the state or local government so the state the company does business in or the state the employee resides in depends on what the employer is required to withhold.
Of the 50 states, there are eight states that currently do not have a state income tax, they include:
- Alaska
- Florida
- Nevada
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
Calculating a state income tax payroll deduction will also depend on the state. Some states have a flat income tax (like the FICA taxes), and others have a progressive income tax system (with brackets based on income, like the federal system). Like federal income tax, employers will also have to look at an employee’s selected allowances. With the large variations, it’s important to consult state or local tax agencies to ensure compliance with regulations.
Court-ordered deductions (Wage garnishments)
The last type of mandatory payroll deduction is court-ordered and will not apply to every employee. These deductions are only for employees with court orders. Employers are responsible to withhold the proper amount based on specific requirements laid out in the court order. There are several scenarios where this might apply including:
- Delinquent child support payments
- Unpaid federal or state taxes
- Defaulted student loans
- Alimony
- Various other monetary fines
The garnishment order will specify the withholding amount or percentage of withholding and where to send the payment. Employers must follow the documents correctly because if garnishments are deducted incorrectly or failed to pay entirely, the business could be liable for the back payments, not the employee.
The types of income that can be garnished include:
- Hourly wages
- Salaries
- Commissions
- Bonuses
- Pensions and retirement plan payments
Voluntary payroll deductions
It’s time to review voluntary deductions. These deductions are not required by law but are based on the benefits employers offer and whether employees are eligible and choose to opt into these benefits. Employers are only required to withhold a certain amount from an employee’s paycheck if they’ve authorized their employer to do so. Not all employees will use the different voluntary payroll deductions that are offered, making it important to properly manage the payroll process.
It’s worth noting that there are pre-tax and after-tax deductions, depending on the specific benefit. With pre-tax benefits, employers withhold the appropriate amount from their employee’s pay before withholding federal employment taxes. With after-tax benefits, employers deduct the appropriate amount after withholding government payroll taxes.
The most common types of voluntary deductions include:
- Health, life, and disability insurance payments
- Union dues
- Retirement or 401(k) contributions (Roth 401(k) contributions are pre-tax)
- Flexible spending account (pre-tax) or health savings account contributions
Let’s explore some of the most common voluntary payroll deductions.
Health insurance premiums and FSA accounts
If an employer offers health insurance options (medical, dental, vision) and an employee chooses to participate in a plan, the employer may be required to deduct the premium from their paycheck. Also, if they choose to contribute to an HSA- or FSA-type account, the employer would also have to deduct that from their paychecks. Depending on the type, it would be a pre- or post-tax withholding.
Retirement and stock plans
If offered, employees may choose to make payroll contributions into retirement plans, such as 401(k)s or IRAs. Should the business be a publicly held company, the employer might also offer employees the ability to purchase stock options which can also be deducted from their pay.
Life and disability insurance
Although many businesses offer standard life and disability insurance plans that they pay for, an employee may decide to increase their coverage and have it withheld from their paycheck.
Commuter benefits
For employees who commute to work, employers might offer plans that allow them to deduct their commuting costs directly from their paycheck.
Once again, with voluntary payroll deductions, employers are responsible to withhold deductions solely based on the benefits employees elect to participate in.
For businesses both large and small, payroll deductions can be a complicated system keeping track of the various mandated and voluntary deductions. There are ways to streamline the process to make it easier on payroll teams, including investing in a payroll software like isolved. Our payroll solutions automate the process – making sure employers always deduct the correct amount and stay compliant with the law.