Time & Attendance
By JD Farrugia
May. 1, 2023
Payroll deductions refer to the amounts that are withheld from an employee’s paycheck by the employer. These amounts are used to pay for different types of taxes, garnishments, or benefits, like covering health insurance premiums. Payroll deductions can be taken out pre-tax or after-tax, and some can be voluntary. They also include statutory deductions that are legally required by the local, state, or federal government to cover specific taxes.
You need to understand the different types of payroll deductions and the importance of adhering to local, state, and federal requirements. Employers are bound by law to withhold and pay mandatory taxes and wage garnishments. Failure to do so will have serious legal implications for your business.
Employers usually make payroll deductions to employee wages every pay period. Employees see the different amounts withheld and their resulting net pay reflected on their pay stub. Employers process payroll deductions based on governmental tax laws or on withholding information given to them by their employees or through a court order.
Many companies use payroll service providers to automate the process. These providers calculate the deductions, withhold the amounts from employees’ pay, and eventually make the payments to the respective entities. The payroll provider also ensures that final payments are filed with the authorities on time to avoid any unnecessary fines.
The amount to be held per employee is outlined in withholding certificates such as the IRS’s Form W-4 Employee’s Withholding Certificate. Other state and local authorities or benefits providers have their own withholding certificates.
There are four types of payroll deductions, and you should understand all of them in order to ensure your company is compliant with state and federal regulations.
Pre-tax deductions are amounts that must be removed from an employee’s gross pay before any taxes are withheld. These amounts, as the name indicates, are not taxable by the local or federal government. Examples of pre-tax deductions are health insurance, life insurance, and retirement plans.
Aside from being non-taxable, they lower the amount of money a company has to pay toward federal unemployment tax (FUTA). FUTA is the system that provides compensation to people who have lost their jobs.
Pre-tax deductions are usually optional for employees, but they can be beneficial for them since they reduce their taxable income and, therefore, increase their take-home pay. The IRS and other entities regulate the amount of pre-tax deductions an employee can claim. For example, the IRS puts a cap on pre-tax deferrals toward 401(k)s per year.
Statutory deductions are mandatory deductions that employers are legally obligated to withhold from employees’ paychecks to be paid as taxes. The government uses the payments received from these deductions to fund public services and programs. These deductions include federal income tax, Federal Insurance Contributions Act tax (FICA), and state income tax.
The status of your workers dictates which of these you need to withhold. For example, unlike full-time employees, an independent contractor won’t require the withholding of deductions related to the Social Security tax or Medicare tax.
In case of any uncertainty, employers can request assistance from the IRS by filling out Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
FICA (Federal Insurance Contributions Act) taxes are a type of statutory deduction used to pay for Social Security and Medicare.
Employees pay 6.2% of their salary toward Social Security tax. There is a contribution limit or cap to this amount based on the wage the employee earns. For 2022, the wage base limit is $147,000.
Medicare tax is set at 1.45% of an employee’s pay and does not include any cap. Employees who earn more than $200,000 could be subject to (based on their filing status) paying additional Medicare tax. More information can be found here on the IRS website.
Federal income tax is an amount deducted from every employee’s salary. The federal government sets different percentages to be paid as taxes from gross salaries based on the amount of money a person earns. The taxable brackets start from 10% and go up to 37% of someone’s gross pay.
A person’s filing status can also affect how much they owe on their federal tax return, for example, if an employee is single or married. An employee’s filing status can be found on their Form W-4.
Different states have different state income tax laws. Some have fixed rates, others adopt a progressive tax approach, and some don’t charge any income tax. States that don’t have any specific tax regulations default to following federal tax laws.
Employers should be familiar with the laws and regulations in the states or cities they operate in.
Employers withhold post-tax deductions after all statutory tax deductions have been processed. In other words, they are taken from an employee’s net pay and not their gross pay. Some examples of post-tax deductions include Roth IRA retirement plans, union dues, charitable contributions, disability insurance, and wage garnishments.
Most post-tax deductions are voluntary, but wage garnishments are withholdings ordered from the courts, the IRS, or other regulatory agencies. They can be used to cover unpaid taxes, child support payments, defaulted loans, or alimony.
Wage garnishments can be placed on an employee’s hourly wages or salary or on any commissions or bonuses they make. They can also be diverted from payments that cover pension or retirement savings plans.
In these situations, an employer receives a garnishment order with instructions relating to a specified amount of the percentage of the withholding. These are important to follow when it comes to payroll since the liability shifts onto the employer if they make an error processing wage garnishments.
Voluntary deductions, as the name implies, are deductions that employees authorize their employers to withhold. They can be withheld pre- or post-tax, and they can be used to cover any benefits that an employee needs to pay for.
For voluntary deductions, employers need to obtain written authorization from employees. Every pay stub should include the monthly deduction as well as the year-to-date total (this is a legal requirement in many states).
Some typical voluntary payroll deductions include:
Because you must calculate gross pay before making payroll deductions, an error in any gross pay amounts can cost the employee as well as the employer. A mistake in an employee’s annual salary can mean they are placed in a higher or lower tax bracket for their federal income tax payments.
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