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What Are Payroll Deductions?
All business owners should know how to calculate net pay and understand payroll withholdings.
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As a business owner, you are responsible for performing payroll withholdings on time and correctly, even if you use a payroll service. These deductions are calculated each pay period and include mandatory withholdings. These withholdings include federal, state and local taxes, as well as FICA (Medicare and Social Security) – and voluntary deductions, like health insurance premiums and 401(k) contributions.
Here’s everything you need to know about payroll deductions, including the types of deductions you may encounter and how to manage them.
What are payroll deductions?
Payroll deductions are amounts withheld from employees’ paychecks each pay period to cover expenses, such as federal, state and local income taxes, as well as employee benefits, like health insurance. These amounts are deducted from each employee’s gross pay to calculate their net pay each pay period.
What are the main types of payroll deductions?
Payroll deductions fall into two general categories: mandatory and voluntary. Mandatory deductions are for payroll taxes, such as income tax and FICA, while voluntary deductions are for benefits (e.g., health insurance and retirement plans).
Mandatory payroll deductions
Here are some typical mandatory payroll deductions:
- Income tax. Deductions for federal, state and local taxes are mandatory, if applicable.
- FICA. Medicare and Social Security premiums are required, and the amounts are based on the employee’s income.
- Wage garnishments. Any court-ordered wage garnishments for taxes, child or spousal support, or other ordered amounts are mandatory.
In certain circumstances, there may be other distributions employers are required to deduct on the employee’s behalf.
Voluntary payroll deductions
Here are some common voluntary payroll deductions:
- Health insurance. If an employee gets health benefits from their employer, any employee portion of the monthly premiums are deducted from the employee’s paycheck. [Looking for more information on health insurance? Check out our small business guide to health insurance.]
- Other insurance premiums. Some employers offer other types of insurance (think life insurance) are also deducted.
- Retirement plan contributions. Employee contributions to employer-sponsored retirement plans, such as a 401(k) or a SIMPLE IRA, are also deducted if the employee elects to participate.
Voluntary payroll deductions are also often called “benefit deductions,” according to Swapnil Shnide, CEO at Zeni, a bookkeeping software.
“Benefit deductions include employees’ contributions to fringe benefits, such as health insurance, life insurance, and retirement plans,” said Shnide. “Depending on local, state, and federal laws, some benefit deductions are taxable, while others may be ‘tax-deferred,’ meaning they’re deducted before the calculation and deduction of taxes.”
The amounts of both mandatory and voluntary deductions can vary over time, though mandatory deductions don’t change much as a result of employees’ decisions, except for altering their number of withholding allowances. Amounts of voluntary deductions, however, can be adjusted.
Items that shouldn’t be deducted
Certain things should not be deducted from an employee’s paycheck. For example, employers are responsible for unemployment insurance (FUTA) and workers’ compensation premiums.
How do payroll deductions work?
Payroll deductions are taken from employee paychecks every pay period. These amounts are calculated for each employee based on their gross earnings for that pay period, potentially with taxes based on an estimate of the employee’s annualized income. Amounts withheld from an employee’s paycheck are then paid on their behalf to taxing authorities, insurers or other recipients.
“An employee’s income tax deduction is determined by the amount they chose to enter on their W-4. Federal and state laws dictate unemployment tax rates. State and local income tax rates, as well as state unemployment tax rates, will differ based on the location,” said Shnide.
Every time an employer runs payroll for their employees who worked during the pay period, each worker’s deductions are calculated based on their earnings. Deductions are then made for income taxes, FICA, garnishments and any other mandatory items, as well as for benefits like health insurance and retirement plan contributions.
“Payroll taxes are the most common form of deduction and include Social Security taxes and Medicare taxes, often referred to as ‘FICA tax,’ after the Federal Insurance Contribution Act that established them,” Shnide added.
Because deductions are based on an employee’s earnings for a particular pay period, it’s important to understand payroll frequency. To learn more, check out our guide to deciding how often to run payroll.
How to calculate payroll deductions
Follow these steps to calculate payroll deductions:
- Calculate gross pay. Add up the employee’s total gross earnings for the pay period.
- Determine the tax rate. Multiply the employee’s annualized income (earnings for the pay period times the number of pay periods in a year) by applicable federal, state and local tax rates.
- Calculate FICA withholding. Include deductions for Social Security and Medicare, which are based on established rates and are subject to income limits.
- Include garnishments. If an employee is subject to court-ordered wage garnishments, calculate those deductions.
- Add voluntary deductions. Divide annual premiums for any voluntary deductions by the number of pay periods.
- Determine the total net pay. Add up all of the mandatory and voluntary deductions, and deduct the total from the gross earnings to determine the employee’s net pay for the pay period.
- Pay the deduction amounts. Once you withhold the deductions from an employee’s paycheck, pay the withheld amounts on the employee’s behalf.
Although you can follow these steps to calculate payroll deductions manually, the process can be tedious and time-consuming, especially for companies with many employees.
“While this is the cheapest option for your business (in theory), the reality is that it’s extremely complex and time-consuming,” said Shnide. In addition to calculating how much you owe your employees, you’ll also be responsible for all related recordkeeping and tax filing and keeping abreast of ever-changing tax laws. Making mistakes or missing deadlines can cost your company significant amounts of money. In most cases, doing your own payroll manually will result in more headaches than it’s worth.
That’s why we recommend choosing a payroll service to do it for you.
“Using payroll software simplifies many of the tedious aspects of handling payroll deductions on your own,” said Shnide.
We’ve done extensive research to find the best companies and software for the job, and you can see our picks for the best payroll services.
Managing payroll deductions
Keeping up with payroll withholdings is crucial for a business owner. Payroll deductions might seem difficult to manage, especially if you have many workers. However, investing in the right payroll service can help streamline the payroll deduction process and ensure accuracy and compliance. The above information should help guide you through your payroll woes.
