Payroll Deductions Explained: How They Work + Various Types

A payroll deduction refers to the wages taken from an employee’s salary to cover payments for taxes, contributions, and other benefits. These deductions can include wage garnishments, 401(k) contributions, and income taxes.

Whether you’re an employer or an employee, it’s important to know how payroll deductions work and understand when each type of deduction is withheld to avoid committing payroll errors and maintain a trustworthy work relationship. So, in today’s article, we’ll discuss everything you need to know about payroll deductions, including their different types and special considerations.

Let’s jump right in!

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?

Payroll deductions work by being withheld from an employee’s wages every month. The company’s Human Resources Department (HR Department) determines the deductions and contributions of each employee and completes a payroll deduction form.

It’s important to 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.

Payroll deductions can also vary depending on the employee’s salary and filing status. For instance, married employees will likely have a higher tax bracket compared to a single employee, which results in a smaller take-home pay. Alternatively, employees with dependents will have fewer tax liabilities, resulting in a higher net income.

Let’s take a look at a quick comparison between different filing statuses:

That said, married couples also have the option to file jointly vs. separately to reduce the amount of payroll deductions on their paychecks.

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.

Payroll Deductions Impact on Take-Home Pay

Payroll deductions have a significant impact on take-home pay, as they reduce the employee’s overall income. For instance, FICA deductions like Medicare and Social Security withheld at a rate of 1.45% and 6.2%, respectively, on a $3,000 salary can result in a net pay calculation of $2,769.

After that, other payroll deduction examples like wage garnishments and voluntary deductions will further reduce an employee's take-home pay. Health insurance and retirement plans, for instance, can reduce net pay significantly.

If an employee chooses to contribute 5% of their salary to a retirement plan, this will deduct an additional $150 from their salary on top of their mandatory and statutory deductions. So, it’s important to understand exactly what these deductions entail in order to budget more effectively and avoid any financial surprises.

Payroll Deductions: Special Considerations

Special considerations for payroll deductions apply to part-time or contractual employees.

While part-time employees are usually subject to the same payroll deductions as full-time workers, they may be exempt from federal income taxes if they have no federal income tax liabilities in the previous and current years. Meanwhile, contractual employees are completely exempt from any withholding taxes from their wages.

It’s also important to keep in mind that some deductions, like Social Security, have an income threshold. This means that if your gross income exceeds $168,600, the amount in excess will no longer be taxed. This cap changes every year, though, and may increase over time, so it’s crucial to stay updated to ensure that you are being taxed properly.

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 wage garnishments?

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

#4. How can employees change their payroll deductions?

Employees can change their payroll deductions by submitting a new W-4 Form to their employer anytime. If you’re planning to do so, we recommend changing your payroll deductions early on to enjoy more significant savings.

#5. What happens if an employer fails to withhold the correct deductions?

If an employer fails to withhold the correct deductions, they will be penalized by the IRS under Sec. 6672 or Sec. 7201 or 7202. The IRS can also claim the employer’s assets until the proper taxes have been paid.

#6. Are payroll deductions taxable?

Payroll deductions can be taxable, depending on the type of deduction. For instance, a part of these deductions are taxes themselves, such as federal, state, and local taxes. Meanwhile, voluntary deductions like insurance and retirement contributions are non-taxable.