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Payroll Deductions: Everything You Should Know

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    Where there’s payroll, there are payroll deductions. But this common aspect of our pay may be more intricate than you think. Payroll deductions aren’t just negative, either, such as those for benefits, savings and retirement plans. Read everything you wanted to know about payroll deductions and how to make managing them easier for HR.

    Payroll deductions are a critical aspect of payroll management, equally impacting employers and employees. Whether you’re an employee who wants to understand the deductions on your pay stub or an employer ensuring compliance and accuracy in payroll processing, it’s important to have clarity around payroll deductions and their different types.

    Let’s dive deep into payroll deductions, unraveling the intricacies and nuances that make up this essential component of paychecks.

    What is a payroll deduction?

    A payroll deduction is a sum of money that an employer withholds from an employee’s salary. These deductions serve multiple purposes, from tax payments to contributions and retirement plans. While some deductions, like taxes and social security contributions, are mandatory, others, like donations to charity and retirement savings plans, are voluntary.

    How do payroll deductions work?

    Understanding payroll deductions is crucial for both employers and employees. An employer, for example, may withhold a portion of an employee’s salary for income taxes. Similarly, employees might choose to have a portion of their pay directed to a 401(k). A variety of factors go into calculating these deductions, including the employee’s earnings and tax brackets.

    What are the most common types of payroll deductions?

    Broadly, payroll deductions can be classified into several types, each serving a different purpose. Here’s a breakdown of all three.

    Mandatory pre-tax payroll deductions

    FICA taxes

    FICA taxes, which get their name from the Federal Insurance Contributions Act, are mandatory payroll deductions used to fund Social Security and Medicare. Employees and employers share equal responsibility to contribute a fixed percentage of the employee’s income, helping provide benefits for retirees, disabled individuals and children of deceased workers.

    Federal income tax

    This deduction is based on the employee’s income and tax filing status, as indicated on their Form W-4. The total amount withheld is determined by federal tax brackets and used to pay the employee’s annual federal taxes.

    State income tax

    Depending on the state, employees may have a portion of their income withheld for state taxes. This rate varies across states, though it’s typically based on the employee’s income level and filing status.

    Local taxes

    In some areas, employees are subject to local taxes, which fund local government initiatives and services. These can vary depending on the municipality.

    Court-ordered deductions

    These include child support, alimony and other court-ordered payments. The amounts are determined by legal judgments and are mandatorily withheld from the employee’s paycheck.

    Mandatory post-tax payroll deductions

    Wage garnishments

    Wage garnishments are enforced by court order, requiring an employer to withhold a portion of an employee’s earnings to pay off debts or obligations, such as unpaid taxes or student loans. The garnished amount is determined by the court and deducted from an employee’s net income after all taxes and other mandatory deductions have been applied. This ensures the employee’s legal obligations are met directly from their salary, minimizing the risk of nonpayment.

    Voluntary payroll deductions

    Consumer benefits

    If desired, employees can have a portion of their salary deducted to cover the cost of health insurance premiums and other benefits-related expenses. These deductions are often pre-tax, reducing the employee’s taxable income, and are used to pay for the employer-provided health insurance plan, which may include medical, dental and vision coverage.

    Health savings account (HSA)

    Employees can contribute to an HSA or flexible spending account (FSA) to set aside pre-tax dollars for eligible health care expenses. These accounts can help you spend less on out-of-pocket costs by using pre-tax income to pay for qualifying expenses like medical procedures, prescription drugs and even child care.

    Life insurance

    Another option is to purchase life and disability insurance through an employer, with premiums deducted directly from their paychecks. Life insurance plans offer financial protection in the event of death or disability, ensuring security for the employee and their family.

    Retirement plans

    Many employees choose to contribute a portion of their earnings to retirement savings plans, the most common of which is a 401(k) plan. These are often pre-tax contributions that can help employees save for retirement; some employers will even offer to match employee contributions.

    How to calculate payroll deductions

    Calculating payroll deductions involves several steps (a process made simpler with automated payroll software):

    1. Gather employee documentation. Employees must complete forms like the W-4 and I-9 and, if applicable, a direct deposit authorization form, to start the payroll process.
    2. Calculate gross pay. Determine the employee’s total earnings before deductions, including wages, overtime, bonuses or commissions.
    3. Calculate tax withholdings. Calculate the amount to be withheld for federal, state (if applicable) and FICA taxes based on the employee’s earnings and W-4 information.
    4. Incorporate deductions. Include both voluntary (retirement contributions, health premiums) and involuntary (garnishments, child support) deductions from the gross pay.
    5. Determine net pay. Finally, calculate the net pay by verifying gross income, subtracting all tax withholdings and deductions, and adding any expense reimbursements.

    How to create a payroll deduction plan

    A payroll deduction plan is a systematic approach where employers withhold a portion of an employee’s salary for purposes like:

    • contributing to a retirement plan
    • paying for insurance premiums
    • setting aside funds for savings programs like a 401(k)

    For example, employees can elect to have a certain percentage or amount of their pre-tax salary deducted each pay period and invested into their 401(k) account, managed by a separate financial institution. Not only does this help employees save for their retirement, it also offers potential tax benefits.

    For the payroll deduction plan to be successful, especially for retirement savings, the process needs to be automated and consistent. Automation ensures that the specified amount is accurately and regularly deducted from the employee’s paycheck and transferred to the designated account — without human intervention. This consistency is crucial for regulatory compliance and the employee’s financial planning, so their savings can grow predictably over time.

    What are payroll deduction loans?

    Payroll deduction loans are a type of loan where repayments are automatically deducted from an employee’s salary. Typically, these loans are facilitated by an agreement between the employer and a lending institution. In other words, you can repay loans through payroll deductions, provided all parties agree to the process.

    Once an employee takes out a payroll deduction loan, the agreed-upon repayment amount is automatically withheld from their regular paycheck and sent directly to the lender. This simplifies the repayment process and reduces the risk of late or missed payments.

    Common payroll deduction terms

    Federal income tax (FIT)

    FIT is a payroll deduction mandated by the U.S. federal government that applies to almost all types of earned income. The amount withheld from an employee’s salary depends on two factors: their income level and the number of allowances they provided on their W-4.

    Throughout the year, employers withhold this tax from each paycheck and remit it to the IRS. Employees then file a tax return at the end of the year to reconcile the total withholdings with their actual tax liability. If too much was withheld, they get a refund; if too little, they owe more taxes. This system is designed to meet the government’s need for regular tax income without placing a heavy tax burden on employees at the end of the year.

    OASDI (Old-Age, Survivors, and Disability Insurance) payroll deductions

    OASDI payroll deductions are critical to the U.S. Social Security program. These deductions — mandated by FICA — are withheld from an employee’s paycheck to fund Social Security benefits. The amount deducted is a set percentage of an employee’s gross earnings, with a cap on the maximum amount of income subject to this tax each year.

    These contributions finance a range of benefits, including:

    • retirement income
    • disability income
    • survivor benefits for the dependents of deceased workers

    This program aims to provide a financial safety net for individuals and families when they need it most.

    Section 125 deduction for payroll

    The Section 125 deduction for payroll, often referred to as “cafeteria plans,” is an IRS provision that allows employees to convert a taxable cash benefit (like a salary) into a non-taxable benefit. Under a Section 125 plan, employees can choose to pay for things like health insurance premiums, dependent care expenses and FSA contributions before any taxes are deducted from their income. This pre-tax deduction reduces employees’ taxable income, lowering their overall tax burden.

    Employers also benefit from reduced payroll taxes. The “cafeteria” part of the name comes from the fact that it offers a variety of benefits for employees to choose from, much like selecting items in a cafeteria. It can provide significant tax savings, which is why it’s a popular component of many employee benefits packages. However, there are rules and limits to what expenses are eligible and how much can be contributed to these plans each year.

    Long-term disability (LTD) payroll deductions

    LTD payroll deductions are contributions toward a long-term disability insurance policy, which provides financial protection to employees in case of an extended illness or injury that prevents them from working for long periods. This helps vulnerable employees safeguard themselves and their families from financial hardships, making LTD payroll deductions a critical component of a comprehensive employee benefits package.

    Typically, these are optional selections deducted as a percentage of the employee’s salary. The specifics of LTD benefits, such as the percentage of salary covered and the waiting period before benefits begin, often vary depending on the policy.

    How can I correct a deduction that was missed or made in error?

    To correct a payroll deduction that was missed or made in error, it’s important to promptly notify the HR or payroll department of the discrepancy. They will review the payroll records, identify the error and make the necessary adjustments to rectify the mistake in the subsequent payroll cycle. This process may involve issuing additional pay or adjusting future deductions to compensate for the error.

    However, the best practice would be to invest in payroll software that allows employees to flag issues before HR has to retroactively fix them.

    How does Paycom prioritize multiple types of payroll deductions?

    Paycom streamlines the prioritization of numerous payroll deductions, including complex scenarios like multiple garnishments. Our software automatically organizes these deductions in accordance with wage and hour laws, ensuring legal compliance and accuracy.

    This prioritization is handled by our software’s intelligent algorithms, which take into account the specific rules and limits for each type of deduction, thereby simplifying what would otherwise be a complex manual process.

    How Paycom simplifies payroll deductions

    The right HR software streamlines payroll deductions in several ways. Consider just a few of these areas where it has the biggest impact.

    Garnishment administration

    Paycom’s Garnishment Administration tool eases the deduction process by automating garnishment calculations based on the employee’s earnings and the legal guidelines. It also:

    • generates insightful reports
    • simplifies record-keeping
    • expedites communication with relevant parties
    • reduces the administrative burden on HR teams
    • eliminates the need for manual data entry

    Payroll tax management

    We also simplify payroll tax management by automating the calculation and withholding of federal, state and local taxes based on current laws and individual employee information. It updates automatically to reflect changes in tax rates and regulations, helping ensure compliance and reducing the risk of errors.

    Paycom also files and remits taxes directly to the appropriate agencies, streamlining the entire tax process. Not only does this save time, it minimizes the risk of penalties due to late or incorrect tax payments.

    Benefits selection and administration

    Paycom’s single software allows employees to easily compare, select and manage their benefits without relying on HR for every question.

    And with an automated enrollment process, deadline tracking and eligibility checks, these systems significantly reduce tedious paperwork and manual processes. They also facilitate benefits-related communication and updates, so employees can make informed choices with up-to-date information.

    Automated payroll services

    Beti®, Paycom’s payroll tool that empowers employees to do their own payroll, builds itself. With the tech’s automated process, deductions automatically populate from one payroll to the next. Then it identifies errors and guides employees — not HR — to fix the mistakes before submission.

    The result? Your people benefit from greater insight into their pay, while HR doesn’t have to worry about manually calculating every payroll deduction.

    Explore Paycom’s resources to learn more about foundational HR topics like this.

    DISCLAIMER: The information provided herein does not constitute the provision of legal advice, tax advice, accounting services or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional legal, tax, accounting or other professional advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation and for your particular state(s) of operation.