Paying employees is a critical component of a small business owner's job. Besides paying your workers on time, you also need to be sure you are paying them accurately. This means you need to have a firm grasp on the payroll deductions, such as taxes and benefit premiums, that should be coming out of each employee's paycheck. While payroll deductions aren't the most straightforward part of running a business, they're easier to understand than you might think.
What are payroll deductions?
Payroll deductions are taxes, benefit payments or wage garnishments that an employer withholds from employee earnings. They may also be called paycheck deductions. You must withhold paycheck deductions for all employees to whom you plan to issue a W-2 form, but not for any independent contractors or freelancers you work with.
What are voluntary versus mandatory payroll deductions?
Discussing the tax break that accompanies pretax deductions brings another payroll tax consideration into clear focus: Not all payroll deductions are mandatory. Some businesses – those that employ 50 or more full-time employees (or the equivalent in part-time employees – must offer health insurance under the Affordable Care Act, but, otherwise, most small businesses aren't required to offer healthcare benefits (and withhold wages for health insurance). Payroll deductions can be classified as voluntary and mandatory payroll deductions.
- Voluntary payroll deductions comprise all benefit-related deductions. Retirement plan contributions and benefit premium payments are examples of voluntary payroll deductions.
- Mandatory payroll deductions comprise all payroll taxes and wage garnishments. All federal, state, and local income taxes, as well as FICA taxes, are mandatory payroll deductions.
- Pretax deductions are removed from the wages before taxes are calculated. Many retirement plans, such as the 401(k), are pre tax. That means that contributions made to a 401(k) are not subject to income tax (at the time the contributions are made).
- Post-tax deductions come after tax calculations. Post-tax deductions do not change an employee's total taxable income, so there are no immediate tax advantages to these deductions. Life insurance, charitable contributions and select retirement plans (like a Roth IRA) are post-tax deductions.
What types of payroll deductions are there?
There are seven types of payroll deductions:
1. Federal income taxes
Federal income taxes pay for the federal government's operating expenses. Every employee's federal income tax withholding rate will differ; to calculate this rate, you'll use IRS Form W-4, which your employees should complete after they are hired. This tax is one of two types of federal payroll taxes.
2. Medicare and Social Security taxes (FICA taxes)
Under the Federal Insurance Contributions Act, employers must withhold Medicare and Social Security taxes from their employees' paychecks. FICA taxes are the second category of payroll taxes, and their rate is uniform among all employees, though these rates change every year.
For 2020, you will withhold 6.2% of each employee's first $137,700 in wages to cover Social Security taxes. You will also withhold 1.45% of each employee's wages – with no wage cap – to cover Medicare taxes.
As part of your employment taxes, which are separate from payroll taxes, your company must also pay FICA taxes from its business income (unless your company is a pass-through entity). These taxes are levied on your company's income at the same rates as on your employees' wages. However, unlike your employee contributions, your FICA employer contributions are fully tax-deductible.
3. State income taxes
These are the state equivalent of federal income taxes. The state income tax withholding rate varies by both employee and state – and some states do not collect income tax at all. Like their federal counterparts, state income taxes are payroll taxes.
4. Local income taxes
In some states, individual municipalities or jurisdictions collect local income taxes as well. Depending on the location, this payroll tax could be based on where you live or work. According to the Tax Foundation, municipalities in just 17 states collect local income taxes.
5. Wage garnishments
Wage garnishments are court-ordered payroll deductions used to pay for an employee's child support requirements or other legal obligations, such as debt. If your company receives a writ of garnishment for one of your employees, you must acknowledge it within seven days. You must also begin withholding the required funds within seven days of receiving the writ.
Your employee can contest a writ of garnishment, and so can you if you receive a writ of garnishment for someone who is not one of your employees.
6. Insurance premiums
When you offer health insurance as one of your employee benefits, your employees are often responsible for paying a portion of it. These payments typically come out of each employee's paycheck. You can also use payroll deductions to expedite your employees' payments for their shares of life insurance premiums.
7. Retirement contributions
If your company offers retirement benefits, employees can choose to have a portion of their wages withheld to contribute to their retirement plans. Whether you set up a 401(k) retirement plan or an individual retirement account (IRA) for your employees, you can set up your payroll to redirect money into your employees' retirement accounts.
8. Job-related expenses
Certain jobs incur certain expenses for employees. Examples of expenses include work uniforms, personal work phones, computers and tablets. Union dues are also frequently included in this category.
How are payroll deductions reported?
You must report mandatory payroll deductions on tax forms. For FICA taxes, you must report and pay these payroll deductions using IRS Form 941 (though in rare cases, the IRS will instruct your company to use Form 944 instead). Each state and local taxation department will have its own required forms as well. The procedure for reporting wage garnishments varies by garnishment category as well.
What are pretax deductions?
Pretax deductions are payroll deductions that you withhold from your employees' gross pay before you withhold payroll taxes. These deductions lower your employees' taxable income, and since you must match the FICA taxes your employees pay on their wages, pretax deductions can offer your company a tax break.
What are incorrect payroll deductions?
This is a term to classify instances where a deduction is wrong. It could be because too much money was withheld, not enough money was withheld, money was withheld for the wrong purpose, or money that should have been withheld was not.
The most common examples stem from miscalculating pay, having the wrong classification for an employee (especially if some workers receive a 1099), missing a deadline and failing to update the company's records.
Is payroll tax a business expense?
Employers may deduct their portion of payroll taxes. Employees, however, cannot.
What payroll deductions are tax-exempt?
There are qualifying voluntary deductions that are tax exempt. The most common are 401(k) and IRA retirement accounts. Some health savings accounts, such as flexible spending accounts, are treated as pretax contributions. Commuter benefits may also be tax-exempt, but they are more restricted.
What types of pretax deductions are there?
In certain cases, you can include the benefits you offer your employees among your tax deductions, because pretax deductions are primarily related to employee benefits.
- 401(k) and IRA contributions: When you use payroll deductions to fund your employees' retirement plans, you can count the money used for these purposes as tax deductibles and lower your employees' taxable income.
- Out-of-pocket portions of health and life insurance premiums: Let's say your company doesn't cover the entirety of your employees' benefit premiums and you use payroll deductions to fund the remainder. You can add that remainder to your list of tax deductibles to reduce your employees' taxable income.
- Other monthly payments for benefit plans: The buck doesn't stop with health and life insurance. There are plenty of other premium-based benefits you can provide your employees – and those too can be deductibles for your employees' taxable income if they have to pay a share out of pocket.
How to calculate payroll deductions
You can automate your payroll deductions using a payroll software program, or you can do all the work yourself. To start, you'll need the following from each employee:
- IRS Form W-4
- Hourly pay rate or annual salary
- Federal income tax withholding rate
- Additional benefit-related payment rates
Then, take the following steps:
1. Determine gross pay.
First, use your employee's income to determine their gross pay for the pay period. Don't forget to pay time and a half for any overtime hours if applicable.
2. Calculate pretax deductions.
Once you have your employee's gross pay for the period, calculate all pretax deductions – benefit-related payments for the pay period – and subtract them from the gross pay. Now, you're ready to calculate mandatory deductions.
3. Calculate federal income taxes.
First, deduct federal income taxes using the information from your employee's W-4 and the federal income tax withholding rates indicated in IRS Publication 15-T. Let's use an example: Assume your employee's gross pay minus their pretax deductions is $3,000 for a given pay period. Using your W-4 info and Publication 15-T, you determine a tax rate of 8%, so you'd multiply 0.08 by $3,000 to get a withheld amount of $240.
4. Calculate FICA taxes.
Next, calculate your employee's FICA tax obligations. For this same employee example, multiply $3,000 by 6.2% for Social Security and 1.45% for Medicare – $182 and $43.50, respectively.
5. Calculate your state and local taxes.
Now, calculate your state and local tax obligations. For this example, let's use 2% and 0.5% for your respective state and local tax rates. You'd calculate $60 and $15 respectively.
6. Calculate wage garnishments.
If needed, calculate your employees' wage garnishments using the court-ordered rate. For this example, if you are required to withhold 25% (a common garnishment rate) for garnishments, you'd multiply 0.25 by $3,000 to get $750.
7. Subtract all deductions from your employee's paycheck.
Now that you've calculated all your deductions, you have one final step: Subtract them from your employee's gross pay for the period. Then subtract your voluntary deductions as well – it's an easy mistake to forget these deductions, since you used them to calculate your employee's taxable income.
How to streamline your payroll deductions
If you're worried about making mistakes when calculating your payroll deductions, that's OK – you have other ways of calculating and paying your payroll taxes. You can sign up with a payroll software provider to set up automatic payroll approval and deduction for your company. Check out our guide to the best payroll software platforms to find the right choice for your business and streamline your payroll deductions and payments – and ensure you comply with all tax laws.