Payroll deductions are wages withheld from an employee’s total earnings for the purpose of paying taxes, garnishments and benefits, like health insurance. These withholdings constitute the difference between gross pay and net pay and may include:
- Income tax
- Social security tax
- 401(k) contributions
- Wage garnishments
- Child support payments
Some payroll deductions are voluntary and may be taken out of a paycheck on a pretax or post-tax basis as long as the employee provided written authorization. Taxes and wage garnishments, on the other hand, are mandatory and employers who fail to accurately withhold these deductions may be liable for the missing amounts. Payroll deductions are generally processed each pay period based on the applicable tax laws and withholding information supplied by your employees or a court order. The calculations can be done manually or you can automate the process using a payroll service provider. Many businesses choose automation because it reduces errors and ensures that payments are filed with the proper authorities on time.
The amount you withhold for each employee depends upon the individual’s Form W-4 Employee’s Withholding Certificate, state and local withholding certificates, benefit selections and other details. For instance, has the employee enrolled in your health insurance plan or is there a court-ordered garnishment to comply with? Your place(s) of business and where your employees perform services also play a factor in payroll deductions because not every state collects income tax.
Pretax deductions
Pretax deductions are taken from an employee’s paycheck before any taxes are withheld. Because they are excluded from gross pay for taxation purposes, pretax deductions reduce taxable income and the amount of money owed to the government. They also lower your Federal Unemployment Tax (FUTA) and state unemployment insurance dues. Types of pretax deductions include, but are not limited to, health insurance, group-term life insurance and retirement plans. And while employees are not required to participate, it’s often in their best interest to do so. Pretax contributions can save them considerable money compared to what they would pay for benefits and other services post-tax.
The savings, however, are not limitless. There are usually caps on how much employees can contribute on a pretax basis. The IRS, for instance, regulates the total amount that can be deferred pretax to a 401(k)-retirement plan each year.
Statutory deductions
Statutory deductions are mandated by government agencies to pay for public programs and services. They consist of federal income tax, Federal Insurance Contributions Act (FICA) tax (Medicare and Social Security) and state income tax. To file them correctly, you need to know the work status of your employees.
If you hire independent contractors, you usually don’t have to withhold income tax, Social Security tax or Medicare tax from their wages. That’s because these types of workers pay self-employment tax on their income. On the other hand, if someone is a bona fide employee, you’re required to deduct the necessary taxes. You can submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding to the IRS for further assistance.
FICA taxes
FICA taxes support Social Security and Medicare. Employees pay Social Security tax at a rate of 6.2% with a wage-based contribution limit and they pay Medicare tax at 1.45% without any cap. This equals 7.65% in FICA taxes per paycheck (until the Social Security wage base is reached), which you are legally obligated to match.
Some employees may also be subject to Additional Medicare tax. Starting with the pay period in which an individual’s earnings exceed $200,000, you must begin deducting 0.9% from his or her wages until the end of the year. Additional Medical Tax also applies to certain levels of railroad retirement compensation and self-employment income. You’re not required to match this deduction.
Federal income tax
The federal government has seven income tax brackets, ranging from the 10% marginal rate to 37%. These rates are applied progressively, which means that an employee’s wages are first charged at the lowest rate until they reach that bracket’s threshold. They continue to be charged at each subsequent rate until they reach their total gross income or the highest tax bracket.
The taxable income in each bracket varies depending on the individual’s filing status – single or married filing separately, married filing jointly, or head of household – which is noted on Form W-4. Yearly adjustments for inflation by the IRS will also determine the tax bracket thresholds. To withhold federal income tax each pay period, you generally have two options – the wage bracket method or the percentage method – both of which can be found in IRS Publication 15-T.
State and local taxes
State income tax laws vary widely, ranging from simple to complex. Some charge a fixed rate against all income, others have multiple tax brackets and a few charge no income tax at all. Still others follow the federal tax code instead of creating their own. For these reasons, you should consult with all the state governments you operate in to make sure your payroll complies with local regulations.
How to calculate payroll deductions
Calculating payroll deductions is the process of converting gross pay to net pay. To do this:
- Adjust gross pay by withholding pre-tax contributions to health insurance, 401(k) retirement plans and other voluntary benefits.
- Refer to the employee’s Form W-4 and the IRS tax tables for that year to calculate and deduct federal income tax.
- Withhold 7.65% of adjusted gross pay for Medicare tax and Social Security tax, up to the wage limit.
- Deduct 0.9% for Additional Medicare tax if year-to-date income has reached $200,000 or more.
- In states that charge income tax, withhold it according to the instructions found in each state’s employer’s tax guide or tax code.
- Subtract garnishments, contributions to Roth IRA retirement plans and other post-tax dues to achieve the total net pay.
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