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Payroll deductions are the specific amounts that you withhold from an employee’s paycheck each pay period. There are two types of deductions: voluntary deductions, like health insurance and 401(k) deductions, and mandatory deductions (or those required by law), like federal income taxes and FICA taxes. Although you’ll withhold payroll deductions from each employee, the specific deductions and amounts will vary based on your employee’s withholding allowances, any state or local taxes, and the benefits your business offers.
When it comes to HR for your small business, there are a variety of essential processes that contribute to how your employees, and your organization as a whole, operate on a day-to-day basis. Perhaps one of the most important of these HR tasks (especially for your employees), is payroll processing—after all, this is how your employees receive compensation for their work. This being said, payroll is also significant for the tax implications it has—for both you and your employees. Not only does your business have to pay payroll taxes, but as an employer, you’re also responsible for payroll deductions, withholding specific amounts from your employees’ paychecks.
What exactly are payroll deductions? What payroll deductions are required by law? This payroll deduction guide is here to help you answer those questions and more. Keeping in mind the importance of the payroll process, we’ll break down the payroll deductions definition, discuss the two different types of deductions, and offer tips to ensure that you have all the information you need to efficiently manage this aspect of your small business HR operations.
First, let’s go through the basics and offer a payroll deductions definition. In essence, payroll deductions are amounts that you withhold from your employees’ paychecks each pay period. When you run payroll, therefore, you’re responsible for ensuring that the proper payroll deductions are taken from each employee.
When an employee receives their paycheck, then, they’re actually getting their net pay, as opposed to their gross pay. Gross pay is the total amount before payroll deductions, whereas net pay (also called take-home pay) is the pay the employee actually “takes home” after deductions. Your employees should see a break out of their payroll deductions for each pay period with their paystub, which is typically generated automatically if you use payroll software.
This being said, there are two different types of payroll deduction: mandatory and voluntary payroll deductions. Mandatory payroll deductions are those that are required by law, like federal and state income taxes. Voluntary, on the other hand, are payroll deductions that your employees can elect to have, such as in the case of insurance or retirement plans.
As we mentioned earlier, and as we’ll discuss in greater detail shortly, considering the two different types of deductions and the specifics involved with each, payroll deductions will vary from employee to employee and business to business. Moreover, it’s also important to note here that payroll deductions are specific to employees—meaning that you’re not responsible for payroll deductions for independent contractors, only your employees.
Now that we’ve gone through the basic payroll deductions definition, let’s dive into the details of the first type of deduction, mandatory deductions.
As we mentioned, mandatory payroll deductions are those that are required by law, whether by federal, state, or local government. These deductions are used for tax purposes—as the employer, you withhold these mandatory payroll deductions from your employees’ paychecks and submit them to the IRS (or appropriate local agency) for payroll taxes.
Therefore, because these deductions contribute to your payroll tax liability, it’s important to ensure that you consistently withhold the correct amounts when you run payroll. If you neglect to withhold these deductions, you’re responsible for the error, and failure to comply with the law in this way can lead to fines and penalties.
With this information in mind, let’s break down the different mandatory payroll deductions, starting with federal income tax.
As an employer, you’re responsible for deducting federal income taxes from each of your employees’ paychecks every pay period. Federal income taxes, of course, are regulated by the federal government and are used for national programs like defense, education, and community development.
The payroll deduction amount that you withhold from an employee’s paycheck depends on their gross pay, as well as the allowances they claim on their W-4. Overall, the amount of federal income tax an employee pays from this deduction will range from 10% to 37% of their wages.
If you use an automatic payroll service, the system will be able to calculate the appropriate federal income tax payroll deductions per pay period based on the relevant employee information (W-4, pay period, gross pay). However, if you need to calculate this deduction manually, the IRS provides instructions in Publication 15 on how to do so.
The next mandatory payroll deductions you must withhold from employees’ pay are those for FICA taxes. Like federal income taxes, FICA taxes are regulated by the federal government—these taxes, however, are comprised of three individual taxes.
FICA taxes are made up of social security taxes, Medicare taxes, and if applicable, the Medicare surtax, and they fund the social security and Medicare programs. With this payroll deduction, you’re not only responsible for withholding the appropriate amount from your employees, but paying an employer portion as well.
This being said, unlike federal income tax, FICA tax payroll deductions are calculated using a flat rate that’s designated by the government. For the social security tax portion, you must withhold 6.2% of an employee’s annual wages, up to $132,900. For the Medicare tax, you must withhold 1.45% of an employee’s annual wages. The Medicare surcharge tax, on the other hand, only applies once an employee’s wages reach $200,000—and then you must withhold 0.9% of their wages that exceed this amount.
Therefore, excluding the Medicare surcharge, you’re responsible for withholding a total of 7.65% of your employees’ pay from their check each pay period to comply with the FICA tax mandatory payroll deduction.
Similar to federal taxes, individual states and municipalities might also require that employees pay income or other specific taxes and that you, as the employer, withhold the appropriate payroll deductions from their wages.
As you might expect, these requirements will vary based on the state or local government. This being said, however, only seven out of the 50 states do not have a state income tax, so you’ll want to remember that this is the state-mandated payroll deduction that you’ll most often see.
Additionally, in this case, the way you calculate a state income tax payroll deduction will also depend on the state, with some states having a flat income tax (like the FICA taxes we discussed above), whereas others have a progressive income tax system (with brackets based on income, like the federal system).
With the large variation in this type of mandatory payroll deduction, you’ll want to consult your state or local tax agency to ensure that you’re complying appropriately with their regulations.
The last types of mandatory payroll deductions are those that are court-ordered. Unlike the previous three we’ve discussed, these deductions will not apply to every employee. Instead, court-ordered deductions, as the name implies, are only required for employees who are required by a court to pay for a particular reason. Typically, these deductions are withheld for employees who are court-ordered to pay child support, or for those who are court-ordered to pay back a debt they owe.
Therefore, if either of these scenarios applies to one of your employees, you’ll be responsible for withholding the proper amount from their wages, according to the specific requirements laid out in the court order.
Voluntary payroll deductions, on the other hand, are not required by law—but are based on the fringe benefits your business offers and if your employees opt into these withholdings. Therefore, when it comes to voluntary payroll deductions, you only are responsible for withholding a certain amount from an employee’s paycheck if they’ve authorized you to do so. As an example, if an employee opts into a commuter benefits plan with a $100 per month deduction, you’ll withhold this amount from their paycheck to cover the cost of that plan. However, not all employees will decide to utilize all of the different voluntary payroll deductions that your business offers—making it all the more important to properly organize and manage your payroll process.
Additionally, in regard to voluntary payroll deductions, it’s worth noting that there are pre-tax and after-tax deductions, depending on the specific benefit. With pre-tax benefits—typically health insurance, life insurance, certain 401(k) plans—you withhold the appropriate amount from your employee’s pay before withholding federal employment taxes.
With after-tax benefits (some 401(k) plans, disability insurance, life insurance), you deduct the appropriate amount after withholding government payroll taxes.
All of this being said, let’s explore some of the most common voluntary payroll deductions.
Once again, the voluntary payroll deductions you’re responsible for are entirely dependent on the benefits you offer and the elections your employees make. Similarly, the specific amount you deduct from an employee’s paycheck per pay period will also depend on the specific benefit (IRA vs. job-related expenses, for example), as well as which of the voluntary deductions the employee has authorized.
As you can see, understanding and implementing the appropriate payroll deductions for your employees can be a complex process. This being said, however, there are certain actions you can take and tips to keep in mind that can help your business manage payroll compliance.
Using payroll software or working with a payroll service is perhaps the most influential action you can take to streamline your payroll deductions and ensure that your processes are in compliance with government law.
With payroll software, you’ll be able to input all of your employee information, including tax withholdings, benefit elections, pay amount and frequency—and each time you run payroll, the system will automatically calculate the proper deductions and issue employee paychecks accordingly.
As we explored briefly above, when it comes to mandatory deductions like federal income and state taxes, the necessary calculations are complicated, requiring several different considerations and varying based on the individual employee. By using a payroll software, however, you won’t have to worry about any of these complexities, as long as you ensure that you’ve set up your payroll and employee information correctly.
Additionally, payroll software is also beneficial in that it can generate employee pay stubs, allowing employees to see their breakdown of pay and payroll deductions, without you needing to take the time and energy to create these documents yourself.
Moreover, many payroll software systems include payroll tax capabilities, helping you calculate and pay the payroll taxes that your business is responsible for.
The next payroll tip you’ll want to keep in mind is to optimize your onboarding process. The majority of the information you’ll need to accurately complete payroll deductions for your employees will be based on the information they provide—from W-4 tax withholdings to elections for health insurance and commuter benefits.
In order to ensure that you’re withholding the correct amount from your employees’ paychecks from the beginning, you’ll want to create a clear and detailed onboarding process—allowing you to collect the necessary details from your employees’ new hire paperwork as soon as they join your company.
By getting all of this information as soon as possible, you’ll be able to deduct the proper amounts from your employee’s first paycheck, as well as have time to ensure that everything is inputted correctly and completely.
Additionally, in this way, payroll software may offer another benefit—as some systems provide an employee portal that allows your employees to input their tax and benefits information directly into the platform
When it comes to payroll deductions, organization is key. As we’ve explored thus far, payroll deductions vary based on a number of factors—mandatory vs. voluntary deductions, state and local laws, employee elections, and more—and therefore, it can be easy to make an error or miss an important step in this process.
This being said, then, you’ll want to ensure that throughout your onboarding, payroll, and the whole of your HR operations, that you try to stay as organized as possible. You’ll want to have a process established for each step involved in setting up your payroll, adding employee information, calculating paychecks, and adjusting deductions as necessary.
Additionally, you’ll want to have a secure and standardized way to store employee information and data, so you can refer back to tax forms or deduction authorizations if need be. Although this may seem like a simple tip, with a process as involved and detailed as payroll, it’s nevertheless something to keep in mind.
Payroll taxes, as we’ve explained, are tied directly to payroll deductions, not only for your employees, but also for your business. Therefore, it’s important to remember that in addition to the taxes you must withhold from your employees’ paychecks, you have your own business payroll tax responsibilities as well.
You’ll need to pay federal unemployment taxes, FICA taxes on top of those from your employees, and overall, you’ll need to report payroll taxes on a quarterly basis. FICA and income taxes are reported to the IRS using Form 941 and FUTA taxes are reported using Form 940.
One of the most common payroll mistakes that small businesses make is missing payroll tax deadlines, as they’re due quarterly, instead of annually. This being said, then, you’ll want to ensure that part of your payroll process involves managing your business’s payroll tax responsibility, as well as the payroll deductions you must withhold from your employees.
Once again, as we mentioned earlier, using a payroll software program with tax functionality is a great way to help you streamline and stay on top of this process.
Finally, you’ll want to remember to take time, whether on a quarterly (when you file your payroll taxes, perhaps), semi-annual, or annual basis to review your payroll processes and make sure everything is accurate, working properly, and see if there are any ways to improve.
Even if you use payroll software, you never want to assume that everything is running automatically and you never need to look through the system again. Since mandatory payroll deduction errors can lead to fines and penalties from the IRS, it’s all the more important to monitor your processes.
This being said, if through your review processes you find an error, are unsure of something, or simply think you could benefit from outside input, you should never hesitate to ask for help. You can consult a payroll or HR expert, business accountant, tax advisor, depending on the kind of assistance you need. When in doubt, these professionals will be able to answer your questions or point you in the right direction to ensure your payroll deductions process are in the best shape possible.
At the end of the day, when it comes to payroll for your small business, the process involves much more than simply writing a check or sending a direct deposit. With both mandatory and voluntary payroll deductions, there are many different considerations and calculations that need to be managed for each employee with each pay period.
Therefore, as we’ve discussed, it’s important not only to understand the different types of payroll deductions and how they might be calculated, but also to take the steps necessary to process your payroll accurately and efficiently—as well as ensure that you’re in compliance with government payroll regulations.
If you run a very small business, you may be able to manually calculate payroll deductions and issue the appropriate employee paychecks, but keep in mind that utilizing a payroll software is the most effective way to automate and streamline your payroll processes.