Table of Contents

Table of Contents

Easier full-service payroll for small businesses

Do you remember when you got your very first paycheck and it wasn’t the amount you expected? That’s because of payroll deductions, the amount your employer withholds from your earnings. Let’s take a closer look at payroll deductions and why they are important.

What Is a Payroll Deduction?

A payroll deduction is the amount withheld from employee wages by the employer and sent to outside agencies on behalf of employees. Some of these withholdings are required by law, some are voluntary, but all of them are made on behalf of and for the benefit of the employee.

Consider each deduction amount as a transfer of the employee earnings from the point of origin directly to the end account without having to go through the employee. Instead of the employee paying a monthly or annual lump sum amount for benefits, retirement accounts or income taxes, smaller deposits are made over the course of the year through the payroll deductions. A federal income tax bill of $12,000 is usually easier for an employee to pay in $500 increments twice a month through payroll deductions.

Why Are Payroll Deductions Important?

The U.S. Treasury collected $4.05 trillion in revenue last year (2021). Over 50% of that amount was calculated and collected through payroll deductions. These are the funds that keep America’s systems running, providing individuals and families with retirement or disability benefits, keeping the hospitals and nursing care facilities open for the elderly and disabled, and providing income security and economic stimulus payments in times of extraordinary need.

For the individual receiving the paycheck, payroll deductions are important to understand because they can negatively affect the employee’s ability to provide for their basic needs. If the employer withholds more than the properly calculated amount, that employee may not be able to buy gas for the commute back to the office the next day. If the employer withholds too little, that employee may not be entitled to the proper level of insurance coverage that they enrolled for. For any error, whether too much or too little is deducted from the paycheck, or the employee retirement contribution is withheld, there is an entire new level of rules and regulations about how and/or if the employer is entitled to correct the error.

Financially tracking the cost per employee is one of the metrics that any finance team would love to be able to easily calculate. When the payroll deductions for employer paid benefits do not match the amount of the monthly invoice from the benefit provider, it is the payroll deductions that they will look to in their reconciliation process. Imagine the financial struggle it may cause an employee to find out the amount that has been withheld from their wages for three months was not enough for the level of benefits they were enrolled for. Whether or not the deduction is calculated before or after taxes, the net result to the paycheck could also have negative personal finance consequences for an employee.

Mandatory Payroll Deductions

Mandatory or statutory deductions are those deductions that must be withheld by the employer by law. In the U.S., the government has mandated specific payroll deductions be withheld from employee earnings in an effort to both ease the financial burden that an annual tax bill might create for an individual as well as fund the U.S. Treasury on a more regular basis.

The first of these deductions is Social Security tax. Established in 1937, this tax is calculated at 6.2% on the annual income limit, currently $147,200 (SSA Table). Social Security assets must be invested in guaranteed securities which earn additional interest, and are intended to provide retirement income. The second statutory deduction is Medicare tax. Medicare was passed into law in 1965. It is calculated at 1.45% on the first $200,000 of qualified earnings, after which it then increases to 2.35% for the remainder of that specific tax year.

In certain states, employers are required to withhold money for the state-mandated disability insurance program. Payroll deductions are to be withheld from employee earnings too. At the time this article was written, those states are California, Hawaii, New Jersey, New York, and Rhode Island. As a side note, disability insurance premiums are also withheld from employees in the province of Puerto Rico.

There is a misconception that income tax is a voluntary withholding. It is not. The Internal Revenue Service requires that income tax be withheld from the employee wages. However, every employee has the ability, the right, and the responsibility to tell the employer how much income tax to withhold using Form W-4. An individual who receives a refund every year for the same amount might consider submitting a new W-4 to reduce the amount of taxes withheld from their earnings and receive higher paychecks over the year instead.

The opposite is true of individuals who have submitted W-4 forms claiming exemption from income tax, either at the federal or state level, or maybe even both. An individual who receives a larger tax amount due at the end of the year might consider increasing the amount of income tax withheld and making due with smaller paychecks during the year.

The only employees who should have no income tax withheld are those who have claimed exemption. Exemptions must be renewed annually, and new W-4 forms are required from all employees claiming exemption each year by February 15. If an employee does not submit a new form for the year, the exemption must be removed and the employee taxed at the highest available rate.

Voluntary Payroll Deductions

Signing up for benefits can be a daunting task, even for individuals who have been in the workforce for a while. Not only are there different plans and levels to consider, but the premiums that will be paid through payroll deductions and the effect they will have on the net paycheck differ as well. Providing these figures at the time of open enrollment is crucial and will help prevent numerous adjustments once the withholding begins.

Pre-Tax Deductions

For those employees who would rather not pay any taxes from their hard-earned wages at all, there are a number of opportunities to reduce the taxable amount of the earnings through pre-tax payroll deductions. For example, if the employee is qualified to participate in a 401(k) benefit, the amount contributed to the 401(k) account is withheld from the wages before taxes are calculated. The thought process here is that the money will be taxed at a lower rate when it is distributed back to the employee after retirement. IRS qualified Section 125 cafeteria benefit premiums for medical, dental, or vision are also pre-tax for certain calculations.

Post-Tax Deductions

Benefit premium withholdings that do not provide immediate tax benefits to the employee are post-tax payroll deductions. Medical, dental, and vision benefits must qualify as part of a Section 125 cafeteria plan to reduce the taxable earnings, and if they aren’t qualified, then they are post-tax deductions. Post-tax deductions are deducted from the earnings after the taxes have been calculated and withheld first. Roth retirement plans are calculated post-tax by design as the money has already been taxed prior so it is not taxed again when distributed back to the employee after retirement. Supplemental insurance like disability or life may be offered as post-tax benefit deductions.

Miscellaneous Deductions

Depending on the policies and procedures of the employer, employees may be allowed to take loans or advances on their future wages which are paid back through payroll deductions. Employees may be asked to reimburse the employer for their company-provided uniforms through payroll deductions.  When an employee enrolls in a charity match, that deduction is withheld after the tax calculations. It is the responsibility of the employee to declare any contributions to charity at tax time.

In the UK, an employer may offer the employee the ability to purchase a bicycle for commuting through the company’s purchasing department. The employee pays the employer back through payroll deductions over an agreed upon amount of months, with contingencies for full repayment should the employee leave employment before the purchase is completely repaid.

PRO TIP: Avoid using miscellaneous on any payroll earning or deduction records. It is a red flag for auditors and could lead to hours of additional work and research for you and your employer. Every deduction should 1) have a name, 2) be assigned to an account or department account for the financial reporting and 3) be supported by the appropriate paper trail.

Negative Deductions

When learning proper English in elementary school, double negatives were a no-no! With payroll deductions, double negatives equal a positive payment. Using a negative figure in the payroll deduction field can lead to a positive amount added to total take-home earnings.

Expense reimbursement is a good example of this. When an employee buys stamps for the office, instead of reimbursing with petty cash, adding a negative deduction for the total amount on the receipt will reimburse the employee via paycheck without increasing the taxable amount because post-tax deductions are calculated after taxes have been calculated.

How to Calculate Payroll Deductions

Statutory deductions should be calculated by the individual who will be processing the payments. If the payroll processor is lucky, the employer has a payroll calculation service that does the tax calculations. If not, various payroll companies offer free online paycheck calculators and the IRS provides the simplified tax tables online.

Step 1: Determine the Total Earnings

In simplest terms, the total number of hours worked multiplied by the hourly rate is the gross total. Salaried employees typically have the same gross total each pay cycle. Remember that gross total earnings also includes overtime, bonuses, commissions, and shift premiums.

Step 2: Determine the Taxable Earnings

Use the employee benefit enrollment selections to determine how much, if any, of the gross total earnings are non-taxable. For example, the Section 125 benefits need to be deducted, and the 401(k) contribution of 3% needs to be calculated and deducted too.

Step 3: Calculate the Tax

Federal Income Tax

  • Use the pay frequency and information from the employee’s W-4 to identify which tax table to use (see IRS Pub 15-t).
  • Use taxable earning amount to locate the tax amount on the table or calculate the tax amount using the percentage method.

FICA Taxes

  • Social Security = 6.2% on $147,000
  • Medicare = 1.45% on first $200,000, then 2.35% for remainder of tax year

State Income Tax, if applicable

  • Use the pay frequency and information from the employee state withholding form (if applicable) to identify which tax table to use.
  • Double check taxable earnings is correct for the state you’re in as the amount often differs from federal taxable earnings.
  • Use taxable earning amount to locate the tax amount on the table or calculate the tax amount using the percentage method.

Aside from the statutory deduction calculations, the payroll processor should not be calculating any other withholding amounts. Benefit deduction amounts should be audited against the benefit provider invoice and necessary adjustments sent back to payroll. Always have a paper trail or email string readily available as backup in an audit.

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Questions You’ve Asked Us About Payroll Deductions

Social Security taxes are an example of a payroll deduction.
FICA stands for the Federal Insurance Contributions Act.
If there are no payroll deductions, the individual must be a qualified 1099 contractor with a taxpayer identification, business location, etc.

A twenty-something year payroll veteran, Christine was adopted into the payroll profession from Human Resources when it was discovered that she had a knack for rules, details and numbers. She is a results-driven and accomplished global payroll enthusiast with broad experience in both domestic and global payroll teams, ensuring accurate payroll operations through efficient leadership of staff. Joining the American Payroll Association (APA) and getting her CPP certification in 2011, Christine has thrown herself head-first into volunteering for the APA at the local, state and national levels. She obtained her Global Payroll Certification in 2011 as one of the first 50 recipients, and her professional vision is to lead the drive towards global payroll quality assurance procedures that provide simple solutions for compliance, accuracy and timeliness.

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