Payroll Deductions Explained Learn How They Work and More

Payroll deductions are a regular part of every pay period. It is one of the most critical components of a paystub because it has to be calculated correctly through and through.

Whether you’re an employer or an employee, knowing the definition of payroll deductions and understanding when each type of deduction is withheld is paramount. In doing so, you avoid committing payroll errors and maintain a trustworthy work relationship.

So get started and learn all about payroll deductions!

Key Takeaways

• Payroll deduction is the amount withheld by employers from employee wages to pay for taxes, insurance benefits, and other contributions.
• Statutory or mandatory deductions are used to cover FICA taxes and federal, state, and local taxes.
• Wage garnishments are considered mandatory deductions, as they are enforced either by the court or the IRS.
• Voluntary deductions include health and life insurance premiums, retirement benefits, union dues, loan repayments, and group-term life insurance.
• Pre-tax deductions are amounts withheld before taxes are subtracted, while post-tax deductions are applied after taxes are cut from paychecks.

What is a Payroll Deduction?

A “payroll deduction” refers to the amount withheld from employee salaries. It is used to pay for benefits, taxes, and even garnishments. Payroll deductions are either mandatory or voluntary.

Mandatory deductions are wages withheld to pay for federal, state, and local income taxes. FICA taxes are also mandatory, as they are used to fund Social Security and Medicare programs.

Meanwhile, voluntary deductions are used to help fund employee benefits such as retirement and insurance plans, union dues, wage garnishments, and loan reimbursements. Voluntarily withheld wage amounts are optional and may be deducted pre or post-tax.

Pre-tax deductions are subtracted before tax contributions are withheld. They are also not considered a part of an employee’s gross payroll. Post-tax deductions are applied after taxes are subtracted and reduce employees’ net wages.

How Do Payroll Deductions Work?

Essentially, payroll deductions are withheld from employee wages or salaries. The company’s Human Resources Department (HR Department) is responsible for determining the deductions and contributions of each employee.

To calculate payroll deductions, follow these steps:

1. Review each employee’s tax forms to identify their tax bracket and filing status and ensure the correct amount is withheld for their federal income tax.
2. Calculate and deduct their federal taxes, Social Security taxes, and Medicare taxes.
3. Withhold amounts for state and local taxes, if applicable.
4. Subtract contributions for voluntary payroll deduction percentages.

Once you’re done, ensure that all contributions and deductions are enumerated clearly in the employee’s pay stub. Indicate the net pay, or the remaining amount in the employee’s income after taxes and deductions.

Some deductions follow a fixed percentage, while other deductions are based on the employee’s Form W-4. The Form W-4 contains information about an employee’s filing status, dependents (if any), job and income adjustments, and credit amounts that help determine an employee’s federal income tax contributions.

For voluntary deductions, the amount withheld is based on the plan offered by the employer or the employee’s choice to have part of their earnings withheld to fund their retirement or insurance benefit.

FICA taxes follow a fixed percentage that is shared between employers and their employees. Contrastingly, self-employed individuals shoulder the combined employer and employee FICA tax contributions.

Statutory Payroll Deductions

Statutory or mandatory payroll deductions are required by the federal, state, and local governments. The contributions collected for statutory deductions are used to fund government infrastructure projects and programs meant to benefit the elderly, disabled individuals, and low-income households.

In the following section, we’ll go over the statutory payroll deductions in detail.

#1. FICA Taxes

FICA (Federal Insurance Contributions Act) is perhaps one of the payroll deduction abbreviations that employees often see on their pay stubs. It is a type of federal income tax levied to fund Social Security and Medicare programs.

The FICA tax rates for the 2023 and 2024 tax years are retained. For Social Security, the tax rate is 12.4%, and it is divided equally between employers and employees at 6.2% each. Medicare tax rates are set at 2.9% or 1.45% for employer and employee contributions.

Employers use Form 941 to report withheld and paid FICA taxes.

#2. State and Local Income Taxes

Unlike FICA taxes, state and local income taxes vary per state or locale. For instance, not all states withhold income tax deductions from employee payroll. These states include Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.

It is the employer’s responsibility to consult with the authorities in their respective state, city, or county about specific tax regulations. All withheld state and local taxes are reported on Form W-2.

#3. Federal Taxes

Federal taxes encompass a broader scope of deductions in that they are levied on all types of earnings that comprise an employee’s income. The IRS imposes federal income taxes not just on employees or individuals but also on all types of legal entities, such as corporations, proprietorships, and LLCs.

#4. Wage garnishments

Wage garnishments are court-mandated withholdings on a concerned employee’s salary. Garnishments on wages are often required if an employee has financial responsibilities to fulfill, such as child support, credit card debt, alimony, outstanding court fees, and medical fees.

The IRS can also impose wage garnishments if the employee has outstanding or unpaid taxes. Garnishments that are not withheld to pay for unpaid taxes, support, or financial losses should comprise approximately 25% of the employee’s net pay or disposable earnings.

Employers who fail to comply with their employees’ obligatory garnishments by inaccurately calculating their withholding amount are subject to penalties.

Voluntary Payroll Deductions

Voluntary payroll deductions are benefits elected or chosen by employees to be withheld from their income. They may be in the form of health insurance, retirement plans, union dues, loan reimbursements, group-term life insurance, or charitable donations.

The key distinction between a voluntary and mandatory payroll deduction is the need for employee consent to withhold the former from their wages. Employers may withhold voluntary deductions pre- or post-tax.

Pre-tax voluntary deductions must be permitted under Section 125 of the IRS. The employee’s taxable income is reduced if voluntary contributions are deducted pre-tax.

#1. Health Insurance

Offering health insurance plans to employees is highly favorable because it boosts employee morale and drives higher employee retention. Health insurance includes medical, dental, and vision coverage, prescriptions, and checkups.

Typically, health insurance contributions are withheld from employee pay before taxes are deducted. Employees can itemize their employer’s out-of-pocket deductions on their tax returns as long as the medical expenses cost more than 7.5% of the employee’s adjusted gross earnings.

#2. Retirement Plan

Retirement plans help supplement the earnings generated by Social Security programs by the time employees retire. Employees can choose to have their retirement deductions fund their retirement plans.

The most common types of employer-sponsored retirement plans are:

• 401(k) plans. A profit-sharing retirement plan offered by private and for-profit entities. 401(k) enables employees to elect a percentage of their wages to fund their individual plans. Employers may contribute to their employees’ 401(k) plans.
• 403(b) plans. This is a type of retirement plan provided by nonprofit and tax-exempt organizations such as charities and public schools.
• 457 Plans. These plans are offered by public employers working for the state or local government. In some cases, tax-exempt employers are also allowed to offer 457 plans to their staff.
• Employee stock ownership plans (ESOP). It is a retirement plan wherein employees’ contributions grant them full or partial ownership of the company where they are employed.
• Pooled employer plans. A plan offered or facilitated by multiple employers (typically belonging to a trade group) to help lift as many executive burdens from employees.
• Simplified employee pension (SEP). SEP provides businesses with a streamlined method to contribute to employees’ retirement benefits while helping reduce their taxable income and increase contribution limits.
• SIMPLE IRA plans. It is similar to SEP, but it caters more to small business owners. In a SIMPLE IRA plan, employers are required to match up to 3% of employee contributions and provide non-elective contributions worth 2% of employee wages.

#3. Union Dues

Union dues are voluntary in that employees can choose whether to be union members or contribute to dues that are used to represent the union. Consequently, employers are required to withhold a portion of employee salaries and remit them directly to the union.

If employees resign from their union membership, they must inform their employer immediately to cancel payments or deductions for their union dues. It is important to note that for the 2018–2025 tax year, union dues are no longer deductible on employees’ tax returns.

#4. Loan Reimbursement

Companies may establish loan programs for their employees, wherein the latter can borrow up to a certain amount and offer payroll deductions as a repayment method.

Deducting loan reimbursements will depend on the loan repayment terms agreed upon by the employer and the employee. Specify the interest rates and number of amortizations in the paycheck to inform employees of the amount they still owe.

#5. Group-term Life Insurance

Group-term life (GTL) insurance is a type of insurance designed for a group of individuals. Basic GTL coverage means that the employer shoulders the majority of the premiums for their employees.

Employees may add beneficiaries and choose premium add-ons, but they will pay for the supplemental coverage. GTL coverage worth $50,000 and below is not subject to tax consequences. Once the coverage amount exceeds $50,000, then the insurance is imputed income.

Final Thoughts

Payroll deductions are a hassle-free method to ensure employees’ investments, taxes, and other expenses are consistently paid.

Any gaps in employees’ tax payments, loan reimbursements, or insurance contributions could lead to penalties and problems in their tax returns, charges, and benefits. But if deductions on wages are made in a timely and systematic manner, it helps employees track their tax returns and obligations accordingly.

Companies are expected to calculate all withholding taxes and contributions with precision. This is to enable full transparency with their employees and the IRS, particularly when disbursing workers’ net pay and reporting the business’s revenue, income taxes, and financial losses.

Payroll Deduction FAQ

#1. What is another word for payroll deduction?

Payroll deduction is also called deduction of earnings, salary deduction, withholding tax, and wage deduction.

#2. What are examples of payroll deductions?

FICA (Federal Insurance Contributions Act) taxes, federal, state, and local taxes, wage garnishments, health insurance, group-term life insurance, retirement plans, union dues, loan reimbursements, FUTA (Federal Unemployment Tax), and SUTA are examples of payroll deductions.

#3. What are mandatory payroll deductions?

Federal and state income taxes, FICA, FUTA, or SUTA, and workers’ compensation insurance are mandatory payroll deductions. These taxes are deducted from employee salaries to help fund the government’s programs for social welfare and security, medical and unemployment assistance, employee death benefits, vocational rehabilitation, and infrastructure.

#4. What are voluntary payroll deductions?

Voluntary payroll deductions are elected by employees as additional withholdings from their gross pay. Examples of voluntary deductions are health and life insurance, union dues, retirement benefits, and loan repayments.

#5. What are wage garnishments?

Wage garnishments are withholdings that are either mandated by the court or the IRS to pay for outstanding tax debts, student loans, child support, alimony, medical fees, bankruptcy, or unpaid taxes.