What Small Business Owners Should Know About Direct Deposit

By Simone Johnson,
business.com writer
| Updated
Jul 23, 2020
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Learn about the pros and cons of using direct deposit payroll services.

  • More than 90% of American employees are paid using direct deposit.
  • Business owners save about $3 per check when they use direct deposit.
  • Businesses can also pay independent contractors using direct deposit.

We've come a long way since paper paychecks. Thanks to direct deposit, your employees no longer need to head straight to the bank on paydays.

While direct deposit is safer, cheaper, greener and an often more efficient way of paying employees, it's not without the occasional problem. Because of how important it is to pay your employees accurately and on time, small business owners must understand how direct deposit works and whether it's right for their businesses.  

What is direct deposit?

Direct deposit is the electronic form of a paycheck. It's an electronic transfer of funds from an employer's business bank account to an employee's account at a bank or credit union. It's also known as an automated clearing house transaction. This process requires the employee's bank account number, routing number, type of account, bank name and address, and the names of the account holders listed on the account.

Direct deposit isn't used solely for paying wages. "It is also used for tax refunds, retirement benefits, expense reimbursements, investment distributions, and insurance claim payments," said Heather McElrath, senior director of communications at the National Automated Clearing House Association (Nacha).

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What is Nacha?

When it comes to payroll services it's best to get familiar with Nacha, which is also known as the Electronic Payments Association. This nonprofit manages the Automated Clearing House Network, which processes and moves trillions of dollars every year. The ACH moved 23 billion payments, valued at $51 trillion, in 2018. These transactions included direct deposit, Social Security, government benefits, electronic bill payments and person-to-person and business-to-business payments.

The ACH network creates the grid for all American financial institutions to safely transfer money from one bank account to another. Nacha is not a government agency, but it works directly with the Federal Reserve, state banking authorities and the Treasury Department. Nacha has its own rules and code of ethics that ensure business is conducted fairly and with as little risk as possible.

Direct deposit services for small business

Once upon a time, 28 million checks were written daily, according to a study in James McKenney's Waves of Change: Business Evolution Through Information Technology. Today, nearly 93% of American workers are paid using direct deposit, which includes both small and large businesses, according to a 2018 American Payroll Association survey. Like many technological advancements, direct deposit has pushed out its paper predecessor.

"Whether you are a 10-person operation or smaller, or a business of more than 100 employees, you can gain from direct deposit's advantages," said McElrath. Using direct deposit gives you more control over your finances and provides you with up-to-date electronic records of your payments. This electronic record helps clear up any confusion about your payroll deposit and provides a point of reference.

Pros of direct deposit

Direct deposit has a lot to offer in terms of speed and efficiency, proving to be a win-win for both you and your employees. Here are some of the benefits of using direct deposit.

It saves your business money.

Direct deposit, like most online innovations, has a lot to offer. It helps businesses save a lot of money by eliminating manual check preparation. Since there is no need for postage and mailing supplies, it saves business owners about $3 per paper check.

Direct deposit can also be used to pay Social Security benefits. In 2013, the Social Security Administration mandated beneficiaries collect their payments electronically. Child support payments and tax refunds can also be sent using this method. To receive your tax refund this way, inform your tax preparer. If you want to save some of your tax refund, you can disburse funds into several different accounts – you only need to provide your bank account information.  

It saves your business time.

Saving money is always a bonus, but saving time is also a welcome win. With direct deposit, you no longer spend time printing and mailing paper paychecks, and you no longer need to wait for all of your employees to cash their checks. It also saves employees time since they no longer need to wait in line at the bank to cash or deposit their paychecks.

It's more secure than paper.

Direct deposit has a big security advantage over paper checks, which can be lost, stolen or counterfeited. Direct deposit is perceived as more secure by 83% of employees, according to the Nacha survey. In a recent Association of Finance's Payments Fraud and Control Survey, researchers found that checks were the most vulnerable to fraud.

It supports employees' financial health.

Direct deposit allows you to help your employees automatically direct part of their paycheck into their savings accounts. "With split deposit, employees can direct a fixed amount or percentage of their pay into a savings or investment account to help build savings," said McElrath. "As the single biggest influence on employees' use of direct deposit, businesses can play a key role in supporting employee financial health."

Most financial institutions offer free checking when employees use direct deposit, which saves on banking fees, said Kristin Walle, senior vice president of Global Payments and Compliance at Automatic Data Processing, Inc.

It's good for the environment.

Our environment is precious, and when we say direct deposit is greener, we mean it. A 10-person small business that pays employees twice a month uses 10.7 pounds of greenhouse gases each year – that's the equivalent of driving almost 40 miles in your car.

If the same small business switched to direct deposit instead of printing paper checks, it would save 3.7 pounds of paper, 35.7 gallons of waste water from being drained into natural bodies of water, 1.4 gallons of gas, and 4.3 pounds of solid waste, according to the Wagepoint.

Can you imagine the impact on the environment if big corporations like Amazon or Microsoft used only paper checks?

Cons of direct deposit

There are some drawbacks of using direct deposit that you'll want to consider, both for employers and employees.

It's time-sensitive.

Direct deposit is a very time-sensitive process, and depending on an employer's workload, deadlines could be overlooked. If you don't collect all of your employees' time and attendance sheets and process payroll by a certain day and time, the money won't be transferred into your employees' accounts on time. Late checks lead to disgruntled employees, and if you want to speed up the process, it will cost you extra.

There are potential security risks.

Because you need your employees' bank routing and account information to set up direct deposit, you need to have strong security measures in place to protect this sensitive information.

Changing banks means starting over.

Changing banks can also prove to be an inconvenience, because it means changing direct deposit information, so all of your employees will need to submit new authorization forms.

There's no "stop payment" option.

Although it's convenient to use direct deposit to make payments, you can't put a stop on the payment like you can with a paper check – which might be an issue if you make a mistake when calculating employee hours.

You could incur overdraft fees.

If you don't have enough money in your account when funds for payroll are withdrawn, it puts you in the negative – you'll incur overdraft fees, which can be both inconvenient and expensive.

How much does it cost to set up direct deposit for my employees?

Direct deposit may seem to be all about saving time and money, but you can be hit with service fees that range from $50 to $149. Banks may also charge employers each time money is transferred from their account to an employee's. Individual deposit fees can range from $1.50 to $1.90 per transfer.

To find out exactly how much it costs to set up and maintain direct deposit, contact your financial institution or payroll provider.  The financial institution or payment processor pays a fee to use the ACH network, but Nacha does not track fees that a business may incur, McElrath said.

"Generally, [the] cost to use direct deposit are low," McElrath said. "Most companies would save money using direct deposit compared to other payment methods, and any startup costs would be recouped in savings and increased productivity."

What time do payroll direct deposits post?

Direct deposit fund posting is governed by Nacha's rules, which all financial institutions abide by, said Walle. "As a result, the funds are available by 9 a.m. local time at the receiving depository institution on the settlement day," she said. "Many financial institutions 'memo-post' incoming transactions so employees may see a 'pending' transaction prior to funds being available."

Most American employees who use direct deposit are paid at the opening of business, on the Friday of payday. If your business doesn't have set paydays, you can use direct deposit to pay employees promptly using same-day ACH. The payment would post by 5 p.m. on the day the payments are made, McElrath said.

Can you pay contractors using direct deposit?

Businesses can pay independent contractors using direct deposit the same way they pay traditional employees – contractors need to fill out the direct deposit form. "While there may be differences in the specifics of how a contractor is administered in a payroll system, the money-movement mechanics are the same," Walle said.

The difference is that contracted workers are not required to fill out a W-2 during their payroll process like traditional employees. Instead, they fill out W-9 forms, and you provide a 1099 form if you pay them $600 or more per year.

How to set up direct deposit

A small business owner can set up direct deposit in four basic steps. Ultimately, the process will run through a payroll provider or bank, which brings us to the first step.

1. Choose a direct deposit payroll provider.

You will need to set up a payroll service. When shopping around, pay close attention to the services offered, the fees and several other components of direct deposit management.  You can always start by inquiring with your existing bank. They likely manage direct deposit, and their terms and fees can give you a baseline when you compare your options.

2. Collect information from your employees.

Once you have a direct deposit provider, you will need information from your employees in order to process the payments. Each provider will provide you with their own direct deposit forms, but some information will prove universal. Make sure that every employee has the ability to safely and reliably provide the following information:

  • The key numbers. There are three numbers that are absolutely necessary to set up direct deposit. These are the employee's bank account number, routing number and Social Security number. The account number is obvious; it tells the provider where to deposit funds. The routing number is necessary for a digital transfer, and the Social Security number provides an additional check on identity to make sure the money goes to the right person.

  • Personal information. This will vary by provider, but the employee's name and address are pretty standard. This is all for verification to avoid mixups and problems with deposit delivery.

  • Consent and authorization. The provider will need to cover the legal basis and assure that the employee understands the agreement and is entering into it willingly.

3. Add employees to the payroll system.

Before you were using direct deposit, you still had a payroll system. The new method will require a system update. You will be running your payroll through the new provider, and that will require an exchange of information. It may take a little time to set up, but once you have everyone in the new system, it should prove easier to manage. Automation features can help you stay ahead of payroll and have everything processed quickly, easily, and consistently.

For many small businesses, the transition to direct deposit does not happen all at once. Some employees may opt out for any number of reasons. You may find yourself using a hybrid payroll system – at least for a while. The good news is that the automation available with direct deposit can make a hybrid system ultimately easier to use than having to write out checks for every single employee.

4. Select your deposit schedule.

Once your provider has all of the necessary information and reviews your orders, they will handle the actual process of depositing the checks. In order for them to do this, you will need to pick a deposit schedule. There are a few things to consider when selecting the schedule.

The first is your own financial schedule. Funds need to be liquid and available for transfer in your business account before paychecks can be distributed. Make sure you pick a payment schedule that works with your expected cash flow.

The second consideration is payment time. Employees depend on those checks, and they need to be received in a timely fashion. When the ACH distributes funds to employees' banks, the process is not instantaneous, despite being digital. On average, it takes two business days for money to go from your business account to your employees' accounts. Depending on the banks involved, downtime will be expanded in the case of holidays.

Simone R. Johnson was born and raised in New York City. She graduated from the University of Rochester in 2017 with a dual degree in English language media and communications and film media production. She has been a reporter for several New York publications prior to joining Business News Daily and business.com as a full-time staff writer. When she isn't writing, she enjoys community enrichment projects that serve disadvantaged groups and rereading her favorite novels.
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