Payroll deductions are wages withdrawn from your employees’ paychecks to pay for taxes, employee benefits, and wage garnishments.
This article will explain payroll deductions and the differences between mandatory and voluntary deductions so that you can effectively manage payroll deductions in your business.
What Are Payroll Deductions?
Payroll deductions are a percentage of an employee’s earnings withdrawn from each paycheck. Payroll deductions can function as either pre- or post-tax deductions and can include:
- Income tax
- Unemployment insurance tax
- Court-ordered garnishments
- Federal Insurance Contributions Act (FICA) taxes
- Health insurance premiums
- Union dues
- Retirement plan contributions
- Health savings account contributions
Pre-tax deductions are taken out of an employee’s paycheck without being taxed. Contributions to health insurance and retirement plans are two common types of pre-tax deductions. Pre-tax deductions can reduce taxable income and unemployment taxes. Most employees will benefit from pre-tax deductions because they can help them save money that otherwise would have been owed in taxes.
Post-tax deductions are taken out of an employee’s paycheck after taxes have been withheld. Post-tax deductions include Roth individual retirement account (IRA) contributions and wage garnishments, as well as some types of disability insurance.
Payroll deductions are calculated based on several factors, including the information from W-4 forms, whether your employees participate in company-sponsored health insurance or retirement plans, and whether your employees are subject to court-ordered wage garnishments.
You can handle payroll deductions yourself or use a payroll service provider to manage them. If you choose to do payroll deductions yourself, you should ensure that the correct amounts are deducted in the proper order, as the order they’re withdrawn can affect your bottom line. You are responsible for sending payroll deductions to the appropriate recipients.
Mandatory Payroll Deductions
Employers must pay mandatory payroll deductions to tax agencies and creditors. Mandatory payroll deductions can include:
- Income taxes
- FICA taxes
- Unemployment insurance taxes
- Wage garnishments
Federal Income Tax
The federal income tax withheld from an employee’s paycheck depends on their earnings, marital status, and the number of allowances on their W-4. You can use information from the Internal Revenue Service’s (IRS) Publication 15-T to determine how much federal income tax to withhold from your employees’ paychecks.
There are seven income tax brackets for the 2023 tax year, ranging from 10-37%, which were adjusted to reflect 2022’s high inflation rates. That means your employees may be in a lower tax bracket than last year.
State and Local Income Tax
State income taxes vary by location and depend on where employees live and work. Not all states collect state income tax. States without a state income tax are:
- Alaska
- Florida
- Nevada
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
States with state income tax generally either have a flat tax, meaning that all income is taxed at the same rate across the board, or a progressive tax, where individuals with higher taxable incomes pay higher tax rates.
Depending on your location, employees may also be required to pay county, city, or school district taxes. You may be responsible for deducting from their paychecks and sending to the appropriate agencies.
State Unemployment Insurance
Most employers in all states must pay Federal Unemployment Tax Act (FUTA) tax and State Unemployment Tax Act (SUTA) tax. The money from unemployment insurance taxes helps support eligible individuals who have lost their jobs while they look for work.
Alaska, New Jersey, and Pennsylvania are the only states that require employers and employees to pay state unemployment insurance. If your business operates in Alaska, New Jersey, or Pennsylvania, you must withhold state unemployment insurance from your employees’ paychecks.
Court-Ordered Garnishments and Payments to Creditors
Courts or the IRS may determine that a portion of an employee’s wages is taken from their paycheck to pay money owed. Wage garnishments pay for taxes, child support, loans that have gone into default, or alimony. You must correctly deduct garnishments and send the payment to creditors, or you may be responsible for paying the amounts owed.
You must also comply with the Consumer Credit Protection Act (CCPA), which restricts wage garnishment to the lesser amount of either 25% of an employee’s weekly earnings or how much the employee’s weekly earnings exceed thirty times the federal minimum wage ($7.25/hour).
Social Security and Medicare
FICA taxes fund Social Security and Medicare programs. An amount equal to 15.3% of employees’ earnings must go toward FICA taxes. Employers are responsible for paying half (7.65%) of that amount. Employees’ FICA tax payroll deductions are dependent on their taxable wage base.
The taxable wage base is the maximum amount of earned income an employee is required to pay Social Security taxes on. The taxable wage base for 2023 is $160,200. Single filers that earn over $200,000 or joint filers that earn over $250,000 must pay a 0.9% surtax. Earners of all income levels must also pay a 1.45% Medicare tax.
Employees and employers must each pay the following amounts for FICA taxes:
- Social Security tax: 6.2%
- Medicare tax: 1.45%
- Surtax for single filers earning over $200k or joint filers earning over $250k: 0.9%
Voluntary Payroll Deductions
Voluntary payroll deductions can be pre- or post-tax. They can include health, life, and disability insurance premiums, union dues, retirement plan contributions, and flexible spending account (FSA) or health savings account (HSA) contributions. Employees must agree to voluntary payroll deductions before their activation. You should record voluntary payroll deductions and display them on each pay statement for auditing purposes.
Health, Life, and Disability Insurance Payments
Offering benefits is an effective way to attract long-term employees and can save you and your employees money. Pre-tax deductions for employer-sponsored health insurance reduce taxable income, saving you money.
Some employers choose to offer employees group-term life insurance. Employees generally receive up to $50,000 of group-term life insurance coverage, which is exempt from federal income tax and FICA taxes. Any coverage that exceeds that limit counts as taxable income (minus the amount the employee pays for the insurance) and is subject to FICA taxes.
Business owners can also offer their employees disability insurance and can pay either part or all of the premium. Five states, California, Hawaii, New Jersey, New York, and Rhode Island require businesses to offer employees short-term disability insurance. Depending on the state and what kind of disability insurance you provide, you must remit disability insurance deductions from employees’ paychecks to the state’s taxing agency or the insurance company.
Union Dues
A recent National Labor Relations Board decision requires employers to deduct union dues from employees’ paychecks and send the money to the union even if a collective bargaining agreement has expired. Additionally, employers who had stopped deducting and remitting union dues after an expired collective bargaining agreement may be responsible for paying the dues.
Retirement or 401(k) Contributions
Individual retirement accounts (IRAs) are retirement plans that any individual with earned income can invest in. A 401(k) plan is an employer-sponsored retirement account that employees can contribute to through paycheck deductions. A traditional 401(k) plan allows employees to make pre-tax contributions until age 59 ½, but they must then pay taxes on their withdrawals as they would on other forms of earned income. A Roth 401(k) plan requires employees to pay taxes on their contributions, but they can enjoy their withdrawals tax-free after they retire.
The 2023 contribution limit for a 401(k) plan is $22,500, and employers can choose to match employee contributions. It is important to note that you and your employees will still need to pay FICA taxes on traditional 401(k) contributions.
Flexible Spending Account or Health Savings Account Contributions
FSAs are employer-sponsored savings accounts that many employees use for out-of-pocket health care costs or dependent care expenses.
The 2023 contribution limits FSAs are:
- Health FSA: $3,050
- Dependent Care FSA, per household: $5,000
- Dependent Care FSA, if married and filing separately: $2,500
Your FSA options include:
- Contributing to your employees’ FSAs
- Providing a grace period during which employees can use their FSA funds
- Allowing a limited amount from an FSA to roll over to the next year
HSAs allow people with high-deductible health plans to have money taken out of their paychecks on a pre-tax basis to help cover deductibles, copays, and other medical expenses.
Employees can open HSAs through their employers, or they can open them on their own. Employers can contribute to an employee’s HSA but must be careful not to exceed contribution limits.
The 2023 contribution limits for HSAs are:
- $3,850 for individuals
- $7,300 for families
The main difference between HSAs and FSAs is that individuals can use HSAs as investment accounts, contributing to them each year. Your employees can contribute a pre-tax portion of their paychecks to FSAs or employer-sponsored HSAs.
Conclusion
As a business owner, you should thoroughly understand the different types of payroll deductions and the order in which they should be executed. For instance, let’s say you have an employee who makes $1,000 each pay period. The employee’s deductions for each pay period include:
- $100 health insurance premium
- FICA taxes (15.3% of taxable income)
- $100 wage garnishment for alimony
The $100 health insurance premium is for an employer-sponsored health insurance plan, and is pre-tax, leaving the employee’s taxable income at $900 per pay period. 15.3% of that $900 ($137.70) is owed to FICA taxes, of which you are responsible for paying half. You should take pre-tax deductions from your employee’s paycheck before calculating FICA tax payment, since pre-tax deductions reduce your employee’s taxable income. However, the $100 wage garnishment for alimony is a post-tax deduction, which means it comes out of the employee’s paycheck but doesn’t affect your bottom line as an employer.
Pre-tax payroll deductions include contributions to health, vision, and dental insurance plans, group-term life insurance plans, FSAs, HSAs, and traditional 401(k) plans.
Post-tax payroll deductions can be used to fund Roth IRA contributions, union dues, disability insurance premiums, and wage garnishments.
Finally, you can calculate payroll deductions manually or use a payroll service provider to compute deductions for you.
