One of your top responsibilities as an employer is managing payroll and ensuring compliance with state and federal payroll regulations. One of the key elements of managing payroll is calculating and managing payroll deductions. But what are payroll deductions and how do payroll deductions work? Put simply, payroll deductions are the sums of money that employers withhold from their employee’s paychecks to cover various expenses. In this guide, we’ll dive deeper into a more detailed payroll deduction definition, provide payroll deduction examples and explain how they work.
What Are Payroll Deductions?
Payroll deductions can be described as wages an employer withholds from an employee’s total earnings. Some payroll deductions are mandatory, whereas others are voluntary and are used to pay various expenses, such as income taxes, payroll taxes, and certain deductions, such as those for benefits like health insurance or retirement plans. The pay statement an employee brings home will state their gross income, which is the amount of wages they earned before payroll deductions, and their net income, or take-home pay, which is the amount they receive after all deductions are subtracted from their paycheck.
Types of Payroll Deductions
It’s important to learn about the different types of deductions to understand payroll deductions. Overall, some payroll deductions can be used for employment taxes, whereas others are for voluntary employee benefits. Take a look at some common payroll deduction examples.
- Income taxes: One of the most important payroll deductions employers are responsible for is an employee’s local, state and federal income taxes. The amount of income taxes deducted depends on their tax filing status, exemptions and other factors. These taxes are mandatory.
- Federal Insurance Contributions Act (FICA) taxes: FICA taxes are mandatory federal taxes used to help fund social welfare programs like Social Security and Medicare. Employees are responsible for paying Social Security taxes at a rate of 6.2 percent of their earnings and a Medicare tax of 1.45 percent, totaling 7.65 percent of their paycheck each pay period. Additionally, employers are required to match each employee’s FICA taxes. Some employees may also be subject to the additional Medicare tax, which applies to wages over $200,000, where 0.9 percent of wages above this threshold are deducted to help fund Medicare.
- Wage garnishments: A mandatory payroll deduction that some employees could be subject to are wage garnishments, which come from a portion of an employee’s post-tax earnings to cover child support, unpaid taxes, delinquent loans or other forms of debt. Wage garnishments are ordered by regulatory agencies like the IRS.
- Retirement contributions: Another payroll deduction example is wages used to contribute to retirement plans. Employees may voluntarily contribute a portion of their salary to a retirement savings account, such as a 401(k), Roth IRA or pension plan.
- Health insurance: Many employers offer health insurance coverage to their employees to help cover medical, dental and vision costs, which can be a great benefit to motivate employees and improve retention. Health insurance premiums are deducted from each employee’s paycheck to help cover a portion of health-related expenses.
- Life insurance: Life insurance premiums are another voluntary payroll deduction that employees might opt into, where premiums will be deducted if they choose to participate in the plan.
- Union dues: If an employee is a member of a labor union, union dues may be deducted from their paycheck to cover their membership costs.
- Flexible spending account (FSA) contributions: If an employee enrolls in an FSA, pretax dollars will be deducted to cover eligible healthcare or dependent care expenses.
- Charitable contributions: Some employers may allow employees to make charitable donations through payroll deductions.
How Do Payroll Deductions Work?
So, how do payroll deductions work? Payroll deductions are deducted from each employee’s paycheck each pay period. Pay periods may differ from employer to employer and follow a weekly, biweekly, bimonthly or monthly schedule. Employers must adhere to local, state and federal payroll regulations to maintain compliance and avoid penalties and fees. Businesses can employ the help of a payroll service provider to automate their payroll and reduce the likelihood of errors and miscalculations that might come with processing payroll manually.
To process an employee’s payroll, you will need their Form W-4, which is an employee’s withholding certificate that tells you their tax filing status and the amount of their income to deduct from each paycheck for federal taxes. You will also need information on each employee’s elections, which are voluntary deductions for things like health insurance and retirement plan contributions.
How to Calculate Payroll Deductions
There are several steps that go into deducting wages from an employee’s paycheck. Here are the basic steps on how payroll deductions are calculated:
- Determine gross pay: To start calculating payroll deductions, you first need to determine gross pay, which is the total amount an employee earns before any deductions.
- Calculate mandatory deductions: Next, calculate the mandatory deductions each employee is responsible for paying, such as local, state and federal income taxes, as well as Social Security and Medicare taxes and wage garnishments, if applicable. To calculate mandatory deductions, you will need to assess the employee’s salary or wages earned and their tax filing status. However, for each employee, you must deduct 7.65 percent of their adjusted gross pay for FICA taxes up to the specified wage limit and 0.9 percent for employees whose wages exceed $200,000.
- Calculate voluntary deductions: Once you have calculated an employee’s mandatory deductions, calculate their voluntary deductions, which are those they choose to opt into, such as retirement savings plans, life insurance, health insurance, vision and dental coverage. Calculations will vary on the employee’s elections and the plan details.
- Subtract deductions: Once you’ve tallied an employee’s mandatory and voluntary deductions, subtract them from their gross pay to arrive at their net pay, which is the amount of money an employee will receive.
- Administer pay stubs: In most states, employers are required to provide pay statements with an employee’s paycheck that offer details like their gross pay, deductions and net pay for each pay period.
- Remit deductions: After collecting an employee’s payroll deductions, the final step is remitting them to the appropriate entities, such as the IRS or retirement plan provider.
Legal Requirements and Regulations
When it comes to payroll deductions, there are certain legal requirements and regulations that employers need to abide by to avoid penalties and fees that can hurt their bottom line and reputation. For all employers, regardless of the state where they operate, a federal legal requirement is to pay federal income taxes and FICA taxes that help fund Social Security and Medicare.
However, there are also local and state-specific regulations that can vary. Some jurisdiction-specific regulations may include court-ordered wage garnishments for expenses like child support or unpaid taxes, federal and state minimum wage laws, overtime regulations and compliance with hour laws. Additionally, employers are often required to maintain accurate payroll records with information on wages, deductions and other details for a specific period in the event of an audit.
Payroll Deductions and Employee Benefits
Payroll deductions and employee benefits are closely connected and key components of an employee’s overall compensation package. As an employer, understanding the different types of employee benefits you can offer your team can also help you understand your payroll deduction obligations and what to withhold from each staff’s paycheck. Payroll deductions help fund employee benefits, whether health insurance or retirement plans, which helps attract and retain talent.
Special Considerations
There are special considerations to keep in mind, depending on your industry and line of work. For example, employers who have employees who earn tips, such as restaurant workers, have to ensure tips are recorded daily, and if more than $20 are earned in tips during a month, they have to be reported on Form 4070. That’s because tips are often subject to payroll taxes and deductions.
Common Questions and Misconceptions
There are several questions and misconceptions surrounding payroll deductions. One of the most common misconceptions is that all payroll deductions are mandatory. In fact, only certain payroll deductions are mandatory, such as income taxes and FICA taxes. However, other deductions, such as charitable contributions and retirement plan contributions, are voluntary.
Another common misconception is that all deductions affect take-home pay equally. When it comes to payroll deductions, factors like an employee’s tax filing status can affect their tax-home pay differently than a colleague.
Lastly, another common question is whether all benefits are deducted from gross pay. While some benefits, like health insurance premiums, are deducted from gross pay, others, such as employer-paid insurance or an employer’s match for a retirement plan, are not deducted from an employee’s paycheck.
Work With an Expert Pay Statement and Payroll Tax Partner
Working with a trusted pay statement and payroll tax partner can help alleviate the burden of creating pay statements, so you can have peace of mind knowing you’re accurate and in compliance. At Experian Employer Services, you can outsource your pay statement responsibilities to our team, where our solutions can help maintain accurate payroll records.