What Small Business Owners Should Know About Direct Deposit

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 bank or credit union account. It’s also known as an Automated Clearing House (ACH) transaction. This process requires the employee’s name, bank account number, routing number, type of account, bank name and address.

When you run payroll, employees who have elected to receive their pay via direct deposit will have their paychecks automatically deposited into their bank account. But direct deposit isn’t just for paying wages. 

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“It is also used for tax refunds, retirement benefits, expense reimbursements, investment distributions and insurance claim payments,” said Heather McElrath, a former spokesperson for Nacha (formerly called the National Automated Clearing House Association) and founder of Sandbox Communications.

How to set up direct deposit

A small business owner can set up direct deposit in five 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.

When you’re choosing the right payroll provider for your needs, pay close attention to the services offered, the fees and the various components of direct deposit management. You can always start by asking your existing bank about their service. It likely provides direct deposit management, and the bank’s terms and fees can give you a baseline for comparing your options.

2. Review federal and state laws on direct deposit.

Before you implement direct deposit for your business, consider the relevant federal and state laws. The complete rules regarding electronic funds transfer payroll payments can be found in the Electronic Fund Transfer Act (part of the Comptroller’s Handbook). These are a few of the federal law highlights:

• An employer is responsible for providing each employee with consent and direct deposit authorization forms.
• An employer must collect the employee’s bank information, including the bank name, account type, and routing and account numbers. The employee’s signature must be completed on the above forms.
• Although the employer may require the employee to accept direct deposit (depending on the case and state), the employee can choose the financial institution to receive the payments.

States are allowed to impose additional requirements for direct deposit. While some states only require employers to follow federal laws, most states have supplementary stipulations.

Fourteen states give employers the right to require employees to use direct deposit (according to federal law):

• Arizona
• Indiana
• Kentucky
• Maine
• Massachusetts
• Michigan
• North Carolina
• North Dakota
• South Dakota
• Tennessee
• Texas
• Utah
• Washington
• Wisconsin

Twenty-one states require an employee agreement before the employer can pay employees via direct deposit:

• Alaska
• California
• Connecticut
• Colorado
• Delaware
• Florida
• Idaho
• Illinois
• Iowa
• Maryland
• Montana
• New Hampshire
• New Jersey
• New York
• North Carolina
• North Dakota
• Oklahoma
• Pennsylvania
• Rhode Island
• Vermont
• Wyoming

3. Collect information from your employees.

After you’ve signed up with your preferred payroll provider, you’ll need to collect information from your employees to process their payments. Each payroll service has its own direct deposit authorization forms, but the information requested is typically universal. Make sure every employee can safely and reliably deliver the following information.

• Bank information: The employee should provide the name and address of their bank and list the account holder’s name for the account they want to use for direct deposit.
• Key numbers: Three numbers are necessary to set up direct deposit: the employee’s bank account number (checking or savings), routing number (an ABA 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 identity check to ensure the money goes to the right person.
• Personal information: The employee’s name and address are standard requests; some payroll services may require more details. This is for verification purposes to avoid mix-ups and problems with deposit delivery.
• Consent and authorization: The provider must cover their legal bases and receive assurance that the employee understands and enters the agreement willingly.

4. Add employees to the payroll system.

Setting up your payroll system may take a little time, but once you have everyone’s information in the software, it should prove straightforward to manage. When new employees join your company, you can collect their direct deposit details as part of the onboarding process, which will speed things along. Additionally, automation tools can help you stay ahead of payroll and process everything quickly, easily and consistently.

5. Select your deposit schedule.

Once you and your payroll provider have the necessary information in the system, you need to pick a deposit schedule. There are a couple of things to consider here. The first is your financial schedule. Funds must be liquid and available for transfer in your business account before payments are distributed. Pick a payment schedule that works with your expected cash flow.

The second consideration is the payment time. Employees depend on those payments, and they need to be received promptly. Despite being digital, the process is not instantaneous when the ACH distributes funds to employees’ banks. On average, it takes two business days for the money to go from your business account to your employees’ accounts. Depending on the banks involved, the transfer may take longer during holidays.

For many small businesses, the transition to direct deposit happens in stages. Some employees may opt out. You might have to use a hybrid payroll system for a while, where some workers still get paper checks. The good news is that the automation available with direct deposit can make a hybrid system easier to maintain than a process where you write out checks for every employee.

Pros of direct deposit

Direct deposit, like most online innovations, offers many advantages in terms of speed and efficiency, making it a great option for both you and your employees. “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,” McElrath said. 

Here are some of the benefits of using direct deposit.

It saves your business money.

Direct deposit helps businesses save money by eliminating manual check preparation. Because there is no need for postage and mailing supplies, it saves business owners about $3 per paper check.

It saves your business time.

Saving money is always a bonus, but saving time is also a welcome win. When your entire staff adopts direct deposit, you’ll no longer spend time printing and mailing paper paychecks, and you’ll no longer need to wait for all of your employees to cash their checks to reconcile your business bank account. It also saves employees time, since they don’t have to wait in line at the bank to cash or deposit their paychecks.

It’s more secure than paper.

Direct deposit has a significant security advantage over paper checks, which can be lost, stolen or counterfeited. In a survey on payment fraud by the Association for Financial Professionals, researchers found that checks are the most vulnerable method to fraud. Additionally, according to a Nacha study, more than 75 percent of workers ages 22 to 34 who receive direct deposit cite security as one of the reasons it’s their preferred payment method. Offering direct deposit could even help you attract millennial employees.

It supports employees’ financial health.

Direct deposit lets your employees automatically direct part of their paychecks into their savings accounts or investment funds.

“With split deposit, employees can direct a fixed amount or percentage of their pay into a savings or investment account to help build savings,” McElrath said. “As the single biggest influence on employees’ use of direct deposit, businesses can play a key role in supporting employee financial health.”

Also, according to Kristin Walle, senior vice president of global payments and wage payments at ADP, most financial institutions offer free checking when employees use direct deposit, which saves them on banking fees. (Learn more about ADP’s payroll service below.)

It’s good for the environment.

A 10-person small business that pays employees twice a month via paper checks uses 10.7 pounds of greenhouse gases yearly — the equivalent of driving almost 40 miles. If the same small business switched from paper checks to direct deposit, it would save 3.7 pounds of paper, 35.7 gallons of wastewater from being drained into natural bodies of water, 1.4 gallons of gas and 4.3 pounds of solid waste. 

Cons of direct deposit

There are some drawbacks of using direct deposit that you should consider for both your company and your employees.

It’s time-sensitive.

Direct deposit is time-sensitive, and it’s easy to overlook deadlines when you’re particularly busy. If you don’t collect your workers’ time and attendance sheets and process payroll by a specific time, the money won’t transfer into your employees’ accounts on time. Late payments can lead to disgruntled employees, and if you want to speed up the process, it can cost you extra if your payroll service doesn’t allow unlimited off-cycle payroll runs.

There are potential security risks.

Even though direct deposit is generally more secure than paper checks, there are still security risks. Because you need your employees’ bank routing and account information to set up direct deposit, you must have strong security measures in place to protect this sensitive information.

Changing banks means starting over.

Changing your business’s bank can be inconvenient because it means changing your direct deposit setup, so your employees must submit new authorization forms. If any individual worker changes their bank, they’ll have to update their direct deposit information with you to ensure they continue to receive their paychecks.

There’s no stop-payment option.

Although it’s convenient to use direct deposit, you can’t stop the payment like you can with a paper check, which might be an issue if you make a mistake. Thankfully, leading payroll services, some of which are highlighted below, help ensure error-free payroll processing. Payroll audits can also help you verify that everyone is being paid correctly.

You could incur overdraft fees.

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

Best payroll services for direct deposit

We researched the best payroll services to find a variety of options for small businesses. These providers are more than capable of meeting your direct deposit needs:

• ADP: This vendor has a 70-year track record as an industry-leading payroll service and HR software provider, handling everything from attendance monitoring to business administration. ADP offers direct deposit, as well as special security measures for pay stubs. During onboarding, you can send new hires an invitation to submit their direct deposit and benefits information via ADP’s employee self-service portal. Learn more in our review of ADP.
• Gusto: We love that Gusto syncs with more than 20 time-tracking tools, which is helpful for ensuring employees are paid for the hours they work. Team members can receive direct deposits in their personal bank accounts or Gusto spending accounts. The vendor lets businesses choose between two-day, four-day and next-day transfers, depending on their plan. See a breakdown of the available packages in our review of Gusto.
• QuickBooks: This full-service payroll solution syncs seamlessly with the QuickBooks Online accounting software, which will help you manage your company’s funds. Not only does the vendor offer next-day direct deposit on its base plan, but you can get same-day turnarounds if you opt for a higher service tier. Plus, using the automated payroll option reduces your lift when you’re processing payroll. Get all the details in our QuickBooks Payroll review.
• Paychex: While Paychex is great for facilitating direct deposit, we appreciate that it also offers a number of alternatives, like an e-checks service. There is even a pay-on-demand offering. Meanwhile, the vendor’s mobile app is useful for running payroll on the go, while employees can use it to enroll in direct deposit and view their pay stubs. The app can also be used for timekeeping. Find out more in our Paychex review.

Do employers have access to employee bank accounts with direct deposit?

No, employers do not have access to employee bank accounts with direct deposit. While an employer can request personal banking information or a voided check to set up direct deposit payments, it is illegal for an employer to gain access to your bank transactions and account balance.

Julie Thompson contributed to this article. Source interviews were conducted for a previous version of this article.