Payroll deductions are monies that employers withhold from an employee’s pay. These deductions include withdrawals such as federal income taxes, state income taxes, local income taxes, FICA tax (Social Security and Medicare taxes), medical benefits, retirement savings plans, or wage garnishments.
Some employee pay deductions are mandatory withdrawals such as income taxes, Social Security and Medicare taxes, and court-ordered child support payments. Others are voluntary deductions that the employee has authorized (via written permission) to be taken out of their compensation. Examples of these voluntary deductions include 401K contributions, life insurance, long-term disability insurance, and health savings plans.
Withholdings may be pre-tax or post-tax, depending on the type of deduction. For some benefits, employees may have the opportunity to decide if they want to take the deduction pre-tax or post-tax.
After calculating deductions and withholding the money from an employee’s pay, the employer must ensure those dollars go to the appropriate government agencies, tax authorities, financial institutions, or insurance providers by their required deadlines.
Types of Payroll Deductions
Pre-Tax Payroll Deductions
Pre-tax payroll deductions help reduce the amount of income tax and FICA tax (Social Security and Medicare) an employee will owe to the government. These voluntary deductions are withheld from the worker’s gross earnings before taxes are taken from the individual’s pay. Pre-tax deductions also lower the employer’s unemployment insurance (FUTA and SUTA) obligations.
Examples of Pre-Tax Withholdings
- Health insurance plan contributions – These could include insurance for medical, dental, or vision coverage. Per the IRS, employers must offer a Section 125 plan (also known as a “Cafeteria” plan) to let employees pay their portion of health insurance premiums on a pre-tax basis.
- Health savings account (HSA) deposits – There are limits to how much employees may contribute each year.
- Flexible spending account (FSA) deposits – There are limits to how much employees may contribute each year.
- Traditional 401K retirement plan contributions – These are tax-deferred for federal income tax and state income tax in most states; however, they are subject to FICA tax. There are limits to how much employees may contribute each year.
- Group term life insurance – This could include coverage beyond the basic term life provided at no cost to the employee.
Post-Tax Payroll Deductions
Post-tax deductions come out of an employee’s net pay, the amount remaining after taxes and any pre-tax deductions have been withheld from the employee’s gross pay. Deductions made post-tax do not lower the employee’s taxable income because they are taken from net income rather than gross income.
Examples of Post-Tax Withholdings
- Roth IRA contributions – There are limits to how much employees may contribute to a Roth IRA each year.
- Charitable donations – A charitable payroll deduction lets the donor spread a larger gift out across multiple months, which makes it much easier on personal finances.
- Insurance coverage – This could be supplemental group term life insurance coverage for the worker or their dependents.
- Work-related expenses – This could include items like uniforms, meals, or union dues.
- Wage garnishments – These could cover expenses like past-due taxes, alimony, child support, or loan payments.
- Disability insurance – While this benefit usually gets deducted post-tax, some policies allow for the deductions to occur on a pre-tax basis.
Some deductions (taxes, for example) are required by law and must be remitted to government agencies. Known as statutory deductions, they cover a combination of federal, state, and local withholdings.
Examples of Statutory Deductions
- Federal Income Tax
- State Income Tax
- Local Income Tax
- FICA Tax (Social Security tax and Medicare tax)
- Court-ordered payments
Note: The employer is responsible for half of the FICA tax due and withholds the other half from the employee’s pay.
Short-Term and Long-Term Disability Benefits
Disability insurance benefits cover a certain percentage of an employee’s wages if the individual has been injured or is too ill to work for a period of time. Short-term and long-term disability insurance may be provided on a pre-tax or post-tax basis depending on the policy. If the employee’s contribution is deducted before taxes are applied, the employee will pay tax on their benefits when they receive them. If the employee’s contribution is deducted after taxes are applied, they do not pay tax on any disability benefits they receive when unable to work.
Some states have laws requiring employers to provide short-term disability insurance to their employees.
Costs That Are Not Payroll Deductions
Some payroll-related costs may not be deducted from employees’ pay:
- Workers Compensation Insurance – Workers’ compensation insurance provides medical and wage benefits to people who are injured or become ill at work.
- FUTA – FUTA is a federal unemployment tax that is used to help fund state workforce agencies.
- SUTA – SUTA is a state unemployment tax, which is also known as SUI (State Unemployment Insurance). In some states, a portion of SUTA may be deducted from employees’ pay.
- Equipment and Tools – This includes items employees need to perform their jobs. Some states also restrict withholdings for uniforms and other job-related expenses.
- PPE – This includes personal protective equipment as required by OSHA to help ensure employees’ safety on the job.
How to Calculate Payroll Deductions?
Generally, employers process employees’ deductions each pay period. A variety of factors affect how much should be withheld from an employee’s pay:
- The employee’s gross pay
- Withholding information provided on the employee’s federal (W-4), state, and local withholdings forms
- Applicable tax laws
- Court orders for garnishing wages
- The benefit plans the employee has enrolled in
- Whether the deductions should be applied on a pre-tax or post-tax basis
The five basic steps to withhold deductions and calculate an employee’s net pay include:
- Adjust gross pay by subtracting pre-tax contributions.
- Calculate and deduct federal income tax (using the information the employee provided on their Form W-4 and the current year’s IRS tax tables) from the employee’s adjusted gross income.
- Withhold the employee’s portion of their Social Security and Medicare tax obligation (7.65%t of adjusted gross pay) up to the wage limit for the current tax year. If the employee’s income reaches or exceeds $200,000, deduct and withhold 0.9% for Additional Medicare tax on the compensation in excess of the $200K.
- If the state (or local government) has an income tax, withhold it according to the jurisdiction’s tax code and regulations.
- Subtract and withhold post-tax deductions.
The remaining amount after all deductions are calculated and withheld is the employee’s net pay.
Payroll Tax Account Registration
Employers must establish accounts with government tax agencies to report and remit employee tax deductions.
Federal taxes are associated with a business’s EIN (the federal tax ID number obtained from the IRS).
The processes for state payroll tax registration and registration with local tax collection agencies vary depending on the jurisdiction. Most states and local governments share information about their requirements on their websites.
How to Report Payroll Deductions
At the state and local levels, employers must follow their jurisdiction’s rules for reporting employee withholdings and submitting payments to the proper agencies.
At the federal level, employers typically use the IRS forms listed below to report money withheld from employees’ paychecks:
- Form 940 – Used to report annual FUTA tax.
- Form 941 – Used to report income taxes, Social Security tax, and Medicare tax withholdings quarterly.
- Form 944 – Used instead of Form 941 by small employers whose annual liability for Social Security, Medicare, and withheld federal income taxes is $1,000 or less.
These forms may be submitted electronically or by mail.
Why It’s So Important to Get It Right!
As you can imagine, payroll deduction calculations can get tricky, and in some instances, a business may be responsible for any shortfalls if it withholds deductions from its employees’ pay incorrectly. Moreover, errors in deductions or failure to remit withheld funds to the appropriate agencies on time can result in fines and other penalties, too.
Talk with knowledgeable professionals (e.g., an accountant, HR payroll specialist, or tax advisor) who can assist you in understanding your responsibilities and guide you in setting up and processing payroll accurately. Many companies choose to use payroll software that calculates deductions for them and automates elements of the payroll process. And some opt to use payroll services companies (like our partner Gusto) to handle all their payroll activities.
Learn More About Payroll Processing
- What is Payroll?
- What are Payroll Taxes?
- What is Payroll Processing?
- What is FUTA?
- What is Reasonable Compensation for an S Corporation
- How Do You Set Up Payroll for an LLC or Corporation?
- How Do You Pay Yourself as a Sole Proprietor?
- How Do LLC Owners Get Paid?
- Hiring Family Members in a Small Business
- Independent Contractors vs. Employee
- What Every Small Business Should Know About 1099s
CorpNet Can Help
Hiring employees and need to get your ducks in a row? CorpNet can help you register for your state unemployment insurance and state income tax accounts.